In: Finance
Net present value and internal rate of return are the capital budgeting techniques mostly used to evaluate the projects or investments. For individual projects IRR is used mostly to evaluate the project and NPV is preferable when the projects are mutually exclusive.
NPV stands for Net Present Value, and it represents the positive and negative future cash flows throughout a project’s life cycle discounted today. NPV represents an intrinsic appraisal, and it’s applicable in accounting and finance where it is used to determine investment security, assess new ventures, value a business, or find ways to effect a cost reduction.
IRR or Internal Rate of Return is a form of metric applicable in capital budgeting. It is used to estimate the profitability of a probable business venture. The metric works as a discounting rate that equates NPV of cash flows to zero.
Reasons for prefering NPV instead of IRR in case of mutually exclusive projects are:
> Investors prefer to use NPV because it is easy to calculate and reinvest the cash flows at the cost of capital. But IRR reinvest at calculated IRR. NPV’s presumption is that intermediate cash flow is reinvested at cutoff rate while under the IRR approach, an intermediate cash flow is invested at the prevailing internal rate of return. The results from both methods offer contradicting results in cases where the circumstances are different.
> When there is a conflict in the ranking of mutually exclusive projects between net present value (NPV) and IRR, at that time, NPV criteria supersede IRR criteria because NPV criteria exactly measure the amount by which the value of the firm will increase. The objective of Financial Management in terms of wealth maximization is met, to which extent it can be measured by NPV. IRR will only be able to decide whether a project is worth accepting or not, but what increase in wealth will occur cannot be measured by IRR.
> Differing cash flow patterns and size of the projects are the other reason for prefering NPV in mutually exclusive projects. A small project may have low NPV but higher IRR.
If there are 2 projects having the same initial investment, Project 1 has a higher NPV but Project 2 has a higher IRR. This is because in case of Project 1 more cash flows are in Year 1 resulting in longer reinvestment periods at higher reinvestment assumption and hence it has a higher IRR.
As the NPV is not skewed by the overstated reinvestment rate assumption, hence it is the preferred method.