Final answer:
The Internal Rate of Return (IRR) is a rate at which a project breaks even in NPV terms, while the Net-Present-Value (NPV) represents the dollar value added by the project.
The IRR assumes reinvestment at the IRR rate, which may be unrealistic, whereas NPV uses the firm's cost of capital for reinvestment, which is more practical for comparisons.
Step-by-step explanation:
Comparing the Internal Rate of Return (IRR) approach with the Net-Present-Value (NPV) approach to capital budgeting is essential in understanding the viability of investment projects. The IRR is the discount rate that makes the NPV of all cash flows from a particular project equal to zero. In other words, it's the rate of return at which the present value of the project’s cash inflows equals its initial investment. The NPV, on the other hand, represents the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
While the IRR provides a rate of return that is expected to be generated by the project, the NPV provides a dollar amount that represents the expected increase in wealth from the investment. An IRR higher than the cost of capital suggests that the project is worth investing in, whereas the NPV indicates how much value the project adds to the company—if it's positive, the project is deemed profitable.
One main difference between IRR and NPV is in how they deal with varying rates of capital returns over time. The IRR assumes the reinvestment of interim cash flows at the same rate as the IRR itself, which may not be realistic. Conversely, the NPV allows for the reinvestment of cash flows at a rate reflecting the firm's cost of capital, arguably a more realistic scenario. Additionally, NPV is generally considered better for comparing mutually exclusive projects, while IRR is often used for independent projects where reaching a certain return threshold is the goal.