Risk & Return - a Trade Off Essays

1247 Words Aug 10th, 2014 5 Pages
Risk & Return, a trade off
What is a risk?

Dictionary meaning of risk could be exposure, hazard, uncertainty, and chance. It conveys a negative sense like possibility of incurring loss or misfortune or injury. It is the probability that a hazard may turn into a disaster or, in other words, the probability that a disaster may happen. Fortunately, risk can be foreseen and managed by various ways such as (i) passing it on to others through insurance, guarantees and sub-contracting, (ii) sharing it by formation of consortium or syndicates, or (iii) reducing it by diversification of possessions or portfolio.

What is a return?

It means compensation, gain, income, reward, pay off or yield. It would be notice that the word ‘return’
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There are, however, some problems with IRR when used alone.

It neglects size of the project and treat big and small projects on equal footing.
It presumed that cash flows are re-invested at a constant rate i.e. at the same IRR.
When cash flows change from negative or positive, or vice versa, a unique internal rate of return cannot be calculated
Usually, a financial calculator is used for finding out IRR but it can be found manually through and error.

2- Net Present Value

NPV works out present value of a future income stream. It discounts future income of each year by multiplying by a corresponding Present Value Interest Factor (PVIF). It means if some income is expected in fourth year, the relevant PVIF would also be of the fourth year. Besides, PVIF is decided keeping in view a discount rate based on the same factor used for comparing IRR such as:

Average Weighted Cost of Fund
Opportunity cost
Desired Rate of Return
Market Rate.
3 - NPV and IRR compared:

While IRR is a rate, NPV is a value based on a particular discount rate. (NPV is also known as dollar-weighted rate of return).

Applying NPV using different discount rates will result in different values and consequently different decisions. The IRR method always gives the same results and decision would have to be made keeping in view the factors cited above.

Both NPV and IRR are based on a discounted cash flow and lead to the same

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