Both NPV and IRR are considered scientific techniques of a project’s financial appraisal and both are commonly used. The NPV is an absolute value of a gain or loss, while IRR is a rate of return from a given investment and, therefore, more appropriate for comparison between different project proposals as well as between a given IRR and different costs of capital. In this respect IRR seems to be having an advantage (Osborne, 2010). This, however, may not always be so.
The biggest problem with IRR is that it is not uniquely defined and we may get more than one IRR in some cases.
Let us consider the following cash flow
End of year
Net Cash Flow
0
-1000
1
+2300
2
-1320
From the above cash flow pattern, we find IRR =10% and 20%, but actually both of them may not be correct. In such a situation, we may compel to abandon and the IRR and use Net Present Value criteria to make decision.
Another problem in using IRR is that it does not distinguish between lending and borrowing. For example, in following illustration we have two projects A and B, with their cash flows as
For Example,
Project A is lending (investing) project while project B is borrowing (financing) project. The NPV of A and B at 10% discount rate is
A = - 400 + 600/ (1.1) = - 400 + 545.45 = 145.45
B = +400 - 700/ (1.1) = + 400 - 636.36 = -236.36
If we calculate IRR of these proposals it is 50% and 75% respectively, indicating that the project B is better. The reality is that A has a positive NPV while B is having negative NPV.
Using NPV and IRR may again create problems, when the patterns of each cash flows is different. For example:
NPV at 10% for A is 424.11 while for B it is Rs. 395.94. Thus, A gives a higher NPV. However if we calculate IRR for the two projects, it is 16.75% and 19.18% respectively for projects A and B. This creates a dilemma.
The conflict between the two techniques is mainly due to the differences in the timings of the cash-flows. In project A higher amounts are occurring in the later years of the projects and its NPV will fall faster in respect of increase in discount rates. In project B the major cash flows occur initially hence its rate of fall is slower.
A comparison between NPV, and IRR shows that NPV is the best capital budgeting technique because of its conceptual charity and methodology of calculation.
For Example,
In the above case project X seems to be superior both in respect to IRR, while project Y is better if we go by NPV. In such a situation, decision should be taken on the basis of NPV, (even if other projects have a higher rate of return). This is because the objective of firm is wealth maximization. Project Y creates extra wealth of Rs. 14545 while project X creates wealth of Rs. 2454 only. Hence, NPV rule is always the best when we have to make decision about a specific project or number of projects and when fund constraint is no problem, i.e. funds can be obtained from the market by paying its cost. However, when funds availability is a constraint, i.e. limited funds are available and we have to choose among different alternatives, then obviously NPV cannot work.
References
Osborne, M. (2010). A resolution to the NPV-IRR debate? Quarterly Review of Economics and Finance, 50 (2), ISSN 10629769. , 234-239.
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Both NPV and IRR are considered scientific techniques of a project’s financial appraisal and both are commonly used. The NPV is an absolute value of a gain or loss, while IRR is a rate of return from a given investment and, therefore, more appropriate for comparison between different project proposals as well as between a given IRR and different costs of capital. In this respect IRR seems to be having an advantage (Osborne, 2010). This, however, may not always be so.
The biggest problem with IRR is that it is not uniquely defined and we may get more than one IRR in some cases.
Let us consider the following cash flow
From the above cash flow pattern, we find IRR =10% and 20%, but actually both of them may not be correct. In such a situation, we may compel to abandon and the IRR and use Net Present Value criteria to make decision.
Another problem in using IRR is that it does not distinguish between lending and borrowing. For example, in following illustration we have two projects A and B, with their cash flows as
For Example,
Project A is lending (investing) project while project B is borrowing (financing) project. The NPV of A and B at 10% discount rate is
A = - 400 + 600/ (1.1) = - 400 + 545.45 = 145.45
B = +400 - 700/ (1.1) = + 400 - 636.36 = -236.36
If we calculate IRR of these proposals it is 50% and 75% respectively, indicating that the project B is better. The reality is that A has a positive NPV while B is having negative NPV.
Using NPV and IRR may again create problems, when the patterns of each cash flows is different. For example:
NPV at 10% for A is 424.11 while for B it is Rs. 395.94. Thus, A gives a higher NPV. However if we calculate IRR for the two projects, it is 16.75% and 19.18% respectively for projects A and B. This creates a dilemma.
The conflict between the two techniques is mainly due to the differences in the timings of the cash-flows. In project A higher amounts are occurring in the later years of the projects and its NPV will fall faster in respect of increase in discount rates. In project B the major cash flows occur initially hence its rate of fall is slower.
A comparison between NPV, and IRR shows that NPV is the best capital budgeting technique because of its conceptual charity and methodology of calculation.
For Example,
In the above case project X seems to be superior both in respect to IRR, while project Y is better if we go by NPV. In such a situation, decision should be taken on the basis of NPV, (even if other projects have a higher rate of return). This is because the objective of firm is wealth maximization. Project Y creates extra wealth of Rs. 14545 while project X creates wealth of Rs. 2454 only. Hence, NPV rule is always the best when we have to make decision about a specific project or number of projects and when fund constraint is no problem, i.e. funds can be obtained from the market by paying its cost. However, when funds availability is a constraint, i.e. limited funds are available and we have to choose among different alternatives, then obviously NPV cannot work.
References
Osborne, M. (2010). A resolution to the NPV-IRR debate? Quarterly Review of Economics and Finance, 50 (2), ISSN 10629769. , 234-239.