Question

The NPV criterion is considered the best approach to evaluating projects. Why do some firms still rely on the IRR rule instead?

Answer 1

What is Net Present Value:

NPV is expressed in a dollar figure. It is the difference between a company's present value of cash inflows and its present value of cash outflows over a specific period of time.

What is Internal Rate of Return (IRR) :

IRR stands for internal rate of return. When used, it estimates the profitability of potential investments using a percentage value rather than a dollar amount. It is also referred to as the discounted flow rate of return or the economic rate of return. It excludes outside factors such as capital costs and inflation.

Differences between NPV and IRR :

1. The NPV method results in a dollar value that a project will produce, while IRR generates the percentage return that the project is expected to create. Purpose. The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash flow level of a project.

2. When you are analyzing a single conventional project, both NPV and IRR will provide you the same indicator about whether to accept the project or not. However, when comparing two projects, the NPV and IRR may provide conflicting results. It may be so that one project has higher NPV while the other has a higher IRR.

3. If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it's considered to be financially worthwhile.

4. Everything points to the net present value decision method being superior to the internal rate of return decision method. One issue that business owners also have to consider is the reinvestment rate assumption. IRR is sometimes wrong because it assumes that cash flows from the project are reinvested at the project's IRR. However, net present value assumes cash flows from the project are reinvested at the firm's cost of capital, which is correct.

Conclusion: Based on above points, in most of the cases, using NPV method is beneficial than IRR method. But in the following situation IRR method is more useful than NPV method. So even though NPV criterion is considered best approach to evaluating projects, some firm still rely on the IRR rule in the following situation.

IRR is the best criterion to accept or reject or rank mutually exclusive projects as well as independent projects.

In the case of mutually exclusive projects, selecting projects based on NPV at hurdle rate is misleading. A project selected based on higher NPV at hurdle rate ends-up with negative NPV when discounted by the higher IRR achieved by the counterpart project (with lower NPV). In the case of counterpart project, the NPV is not negative but zero at that higher IRR as the discount rate. This weakness of NPV is not exposed as NPV is a static point estimate (at hurdle rate). The NPV is not an appropriate criterion.

In capital budgeting, mutually-exclusive projects refer to a set of projects out of which only one project can be selected for investment. A decision to undertake one project from mutually exclusive projects excludes all other projects from consideration.