IRR (Internal Rate of Return) can be defined as the discount rate at which the NPV value of the project is equal to 0. If the IRR is higher than the required return of rate, this often means that the project will have a profitable outcome. It is a relative measure and is expressed in percentage value. This method helps in understand the return of the project and is thus commonly used by the business manager.
NPV (Net Present Value) is calculated by subtracting the present value of cash outflow from the present value of cash inflow. It gives the return in currency which the company expects to make out of the project. This method helps in effective decision making for projects with changes in cash flow (Martin, 2018). As the expression is in the form of currency, this is better understood by any people in general.
IRR assumes that all the future cash flow during the project lifetime is reinvested into the project while earning the same IRR over the remaining life of the project. IRR moves money back into the past instead of future with this method so this method is neither realistic nor feasible. This could give inaccurate outcome for projects and a different outcome in the reality. IRR also doesn’t account for the additional shareholder wealth while doing a calculation for the profitability of the project (Dudley, 1972). Another assumption it makes is that any project would require the same amount of investment and based on this itself the project with the highest IRR is considered to be the best one.
NPV, on the other hand, takes into consideration the time value of money. The method assumes that the reinvestment rate is equal to the cost of capital while future cash flows are discounted at the cost of capital (Beaves, 1988). NPV makes a different assumption which is that it is reinvested but at the required rate of return. It takes into account the additional wealth that the stakeholder accommodates while calculating the project’s profitability. NPV assumes that the discount rate is unchanged during the project lifeline as with a different discount rate, the project would have multiple NPV values. It also assumes that the investment is instantly made once the cash flow is recovered. With NPV, the decision to accept a project can’t be revisited meaning if the project is taken today based on it giving positive cash flow but a year down the line once the project shows a negative return to a point the company is better off abandoning the project, traditional NPV assumes that these kinds of outcome isn’t possible.
If a project has both positive and negative cash flow is lots of changes, it gives multiple IRR for the same project. This makes it impossible to select a project simply based on IRR. The result/outcome is displayed in percentage value which is also deceiving. For example, if a project with has an IRR value of 20% for the project with an initial investment of NRs. 100, and the other project just has an IRR value of 15% but with an initial investment of NRs. 10,000. The first project should be selected as per the calculation of IRR but if we look at the value generation, the second one is a lot higher. IRR not accounting for the discount rate changes makes it even less suitable for long-term projects.
NPV fails into taking account the resources that are required to implement the project. It also fails to take into account the risk related to discount rate as the discount rate of today can very well be different during any year of the project lifetime. NPV calculations require us to calculate the future cash flow, most of which are unknown. No matter how well one calculates this, there’s always uncertainty in cash flow forecast further points back at uncertainty in NPV.
Taking into account what NPV and IRR have to offer along with the assumptions and limitations they stand on for the evaluation of two or more mutually exclusive project, it’s better to go with NPV over IRR. As IRR gives multiple values during the lifetime of the project and makes the selection process further complicated whereas NPV makes a realistic assumption (comparatively) and gives a better measure of profitability.
References
Beaves, R. (1988). Net Present Value and Rate of Return: Implicit and Explicit Reinvestment Assumptions. The Engineering Economist , 33 (4), 275-278.
Dudley, C. (1972). A Note on Reinvestment Assumptions in Choosing between Net Present Value and Internal Rate of Return. The Journal Of Finance , 27 (4), 907.
Martin, Y. (2018). Value Creation Mechanics: An Analytical Reduction of Cash Flows and Net Present Value to Accounting. SSRN Electronic Journal , 3-4.
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IRR (Internal Rate of Return) can be defined as the discount rate at which the NPV value of the project is equal to 0. If the IRR is higher than the required return of rate, this often means that the project will have a profitable outcome. It is a relative measure and is expressed in percentage value. This method helps in understand the return of the project and is thus commonly used by the business manager.
NPV (Net Present Value) is calculated by subtracting the present value of cash outflow from the present value of cash inflow. It gives the return in currency which the company expects to make out of the project. This method helps in effective decision making for projects with changes in cash flow (Martin, 2018). As the expression is in the form of currency, this is better understood by any people in general.
IRR assumes that all the future cash flow during the project lifetime is reinvested into the project while earning the same IRR over the remaining life of the project. IRR moves money back into the past instead of future with this method so this method is neither realistic nor feasible. This could give inaccurate outcome for projects and a different outcome in the reality. IRR also doesn’t account for the additional shareholder wealth while doing a calculation for the profitability of the project (Dudley, 1972). Another assumption it makes is that any project would require the same amount of investment and based on this itself the project with the highest IRR is considered to be the best one.
NPV, on the other hand, takes into consideration the time value of money. The method assumes that the reinvestment rate is equal to the cost of capital while future cash flows are discounted at the cost of capital (Beaves, 1988). NPV makes a different assumption which is that it is reinvested but at the required rate of return. It takes into account the additional wealth that the stakeholder accommodates while calculating the project’s profitability. NPV assumes that the discount rate is unchanged during the project lifeline as with a different discount rate, the project would have multiple NPV values. It also assumes that the investment is instantly made once the cash flow is recovered. With NPV, the decision to accept a project can’t be revisited meaning if the project is taken today based on it giving positive cash flow but a year down the line once the project shows a negative return to a point the company is better off abandoning the project, traditional NPV assumes that these kinds of outcome isn’t possible.
If a project has both positive and negative cash flow is lots of changes, it gives multiple IRR for the same project. This makes it impossible to select a project simply based on IRR. The result/outcome is displayed in percentage value which is also deceiving. For example, if a project with has an IRR value of 20% for the project with an initial investment of NRs. 100, and the other project just has an IRR value of 15% but with an initial investment of NRs. 10,000. The first project should be selected as per the calculation of IRR but if we look at the value generation, the second one is a lot higher. IRR not accounting for the discount rate changes makes it even less suitable for long-term projects.
NPV fails into taking account the resources that are required to implement the project. It also fails to take into account the risk related to discount rate as the discount rate of today can very well be different during any year of the project lifetime. NPV calculations require us to calculate the future cash flow, most of which are unknown. No matter how well one calculates this, there’s always uncertainty in cash flow forecast further points back at uncertainty in NPV.
Taking into account what NPV and IRR have to offer along with the assumptions and limitations they stand on for the evaluation of two or more mutually exclusive project, it’s better to go with NPV over IRR. As IRR gives multiple values during the lifetime of the project and makes the selection process further complicated whereas NPV makes a realistic assumption (comparatively) and gives a better measure of profitability.
References
Beaves, R. (1988). Net Present Value and Rate of Return: Implicit and Explicit Reinvestment Assumptions. The Engineering Economist , 33 (4), 275-278.
Dudley, C. (1972). A Note on Reinvestment Assumptions in Choosing between Net Present Value and Internal Rate of Return. The Journal Of Finance , 27 (4), 907.
Martin, Y. (2018). Value Creation Mechanics: An Analytical Reduction of Cash Flows and Net Present Value to Accounting. SSRN Electronic Journal , 3-4.