Corporate Finance it Is Important to Note,

Corporate Finance

It is important to note, from the onset, that for some projects, NPV may be more effective than IRR as far as discounting cash flows is concerned. This is particularly the case given that one of IRR's key limitations is its utilization of only a single discount rate in the evaluation of investments. Essentially, IRR would most likely work perfectly in those instances where, for instance, the two projects being evaluated have a discount rate that is common, have similar risks, and have cash flows that are predictable. It is, however, important to note that over time, discount rates do change. Essentially, with no modification, IRR doesn't capture the flexible discount rates. In the final analysis, therefore, IRR cannot be seen as being appropriate for long-term projects whose discount rates keep changing. IRR users could also face challenges in those instances where the discount rate is unknown. Further, IRR, unlike NPV is also not effective for projects having a mixture of a good number of negative and positive cash flows.

In the light of the above argument, one may wonder why the IRR is frequently used. On this front, it should be noted that unlike perhaps the NPV, the IRR method is much more convenient as far as its reporting simplicity is concerned. For instance, while IRR focuses on only one number in the evaluation of the viability of a project, the NPV method calls for the application of various assumptions - and hence is much more complex.

If I were to be asked to make capital decisions on projects having cash flow streams alternating between inflows and outflows, I would recommend that we make use of the modified rate of return (MIRR) which, according to Peterson and Fabozzi (2004, p. 100), "is a rate of return on the investment, assuming a particular return on the reinvestment of cash flows."

Question 2

From the onset, while sensitivity analysis, as Baker and Powell (2009, p. 290) point out, "measures the change in one variable as a result of a change in another variable," scenario analysis, on the other hand, examines "what happens to profitability estimates such as NPV under several different sets of assumptions." Essentially, scenario analysis, as the authors further point out, is a variant of sensitivity analysis; but differs from sensitivity analysis by virtue of measuring input variables changes and their impact on NPV.