Distinguishing between data returned by Net Present Value (NPV) and Internal Rate of Return (IRR) (two project selection methods), when analyzing a project, is important because these methods can yield contradictory results.
The resulting difference could be due to a difference in cash flow between the two projects.
Net Present Value (NPV) and Internal Rate of Return (IRR) are two of the most widely used investment analysis techniques.
They are similar because both are cash flow models, that is, they incorporate the time value of money, but they differ in their fundamental approach and their strengths and weaknesses.
The NPV is an absolute measure, i.e., it is the amount in dollars/euros/etc. of value added or lost by engaging in a project.
IRR, on the other hand, is a relative measure, i.e., it is the rate of return a project offers over its life, in percentages.
Financial managers and entrepreneurs usually favor performance measurements expressed in percentages rather than absolute values, so they tend to lean toward decisions expressed this way, as is the case with Internal Rate of Return (IRR).
Yet while this rate is usually a reliable method of determining whether a capital investment project is a good investment or not, under some conditions IRR is not reliable, while NPV is.
What is Internal Rate of Return (IRR)?
Internal Rate of Return is a way of expressing a given project’s value as a percentage rather than an absolute value.
In financial jargon, the internal rate of return is the discount rate or the firm’s cost of capital, which causes the present value of the project’s cash inflows to equal the initial investment.
What is Net Present Value (NPV)?
Net Present Value represents positive and negative future cash flows during a project’s life cycle.
NPV stands for an intrinsic assessment and is applicable in accounting and finance where it is used to determine investment security, assess new endeavors, evaluate a business, or find ways to achieve cost reduction.
The most commonly used NPV is found using a cash flow model, making it a more refined analysis than an IRR calculation.
As long as the Net Present Value of a project is greater than zero, the project is considered financially feasible.
Conflict between Net Present Value (NPV) and Internal Rate of Return (IRR)?
The root cause of NPV and IRR conflict lies in cash flow nature, project nature, and project size.
Independent projects are projects where the decision regarding acceptance of one project does not affect the decision concerning the others.
Since all independent projects can be accepted if they add value, no conflicts arise between NPV and IRR. Thus, the company can accept all projects with a positive NPV.
However, in the case of mutually exclusive projects, a conflict between NPV and IRR may arise if one project has a higher NPV but another has a higher IRR.
Mutually exclusive projects are projects where the acceptance of one project excludes the others from further consideration.
Conflict arises because of the relative size of the project or the different cash flow distribution of the projects, and in this case you need to carefully consider which project to accept into your portfolio.
Similarities and differences between NPV and IRR
NPV takes into account the capital cost and provides a dollar estimate of value added, which is easier to understand.
A particularly important feature of NPV analysis is its potential to increase and decrease the rate to allow for different levels of project risk (you might also be interested in knowing more about the risk assessment matrix system).
However, NPV depends on the project scale. Without careful analysis, an investor might select a project with a high NPV while overlooking the fact that many projects with small NPVs could be completed with the same investment, resulting in a higher aggregate NPV.
This requires careful capital rationing analysis.
Project scale, on the other hand, is irrelevant in the case of IRR. Here you will rank a project that requires an initial investment of €1 million, for example, and generates €1 million each in year 1 and year 2 at the same level as a project that generates $1 in year 1 and year 2 each with an initial investment of $1.
This feature makes it a great complement to Net Present Value.
IRR is also easier to figure because it does not require estimating the cost of capital or hurdle rate, but only requires the initial investment and cash flows.
However, this same convenience can become a downside if projects are accepted without a cost of capital comparison.
Yet another rather major weakness is the multiple IRR problem: in the case of non-normal cash flows, i.e., when a project has positive cash flows followed by negative cash flows, the IRR takes on multiple values, making the decision more difficult.
How to decide between Net Present Value (NPV) and Internal Rate of Return (IRR)?
Generally speaking, if a project’s IRR is greater than or equal to the project’s cost of capital, then it would be wise to accept it.
However, if the IRR is less than the project’s cost of capital, it is better to pass it up.
The bottom line is that you never want to take on a project that returns less money than the company’s cost of capital.
Net Present Value is more commonly used since it is a more polished analysis than the IRR calculation.
If rates of return change over the life of the project, in fact, an NPV analysis can include these changes.
Thus, as long as the Net Present Value of a project is greater than zero, the project is considered financially feasible.
To wrap up, the general rule of thumb is to use Net Present Value, while Internal Rate of Return tends to be calculated as part of the capital budgeting process and provided as additional information.