Question

compare and contrast the npv and irr methods of capital investment evaluation

Answer 1

There is an in general convergence between the decision criteria using NPV and IRR. A positive NPV means the project is generating a return more than the return used to discount the cash flow. This means the project is earning a rate higher than the discount rate which should be a reflection of RRR. Hence, the decision criteria in the two cases are reflection of each other. However, there is much more to it than what appears on the face of it. Relative advantages and disadvantages of NPV and IRR methods: NPV is an absolute value (in Rs., $ etc.) unlike IRR, which is a %. There are decision makers who are so stuck with IRR that NPV doesn’t appeal to them. IRR is easier to visualize and interpret than NPV. For conventional projects, the NPV and IRR will agree on whether to invest or not to invest. NPV and IRR may give conflicting results if there is difference in project size, cash flow pattern, project life or cost of capital over the project term. Some examples are shown below. Generally, NPV is preferred for evaluating capital budgeting projects. It is consistent with the objective of maximizing shareholder’s wealth. Shareholder’s wealth is the NPV of the firm’s future cash flows at its weighted average cost of capital. NPV values of individual projects can be added together to estimate the effect of accepting some possible combination of projects. Since IRR is a %, multiple projects can’t be added or averaged to evaluate combination of projects. Hence, Project with highest IRR is preferred. Both the methods have heavy reliance on hurdle rate. Any error in estimating the benchmark rate can lead to a wrong selection of projects by both the methods. NPV is more appropriate in cases where required rate of return for a project varies over the project tenure since discounting can be done at different required rates. In the case of IRR, comparison of project IRR will be difficult with multiple required rate of return. A project will have as many IRRs as many times its cash flow changes its sign. So in a project with a mix of positive and negative cash flows during the tenure of the project, there will be multiple IRRs. However, in most of the cases, it has been seen that just one of them will be a reasonable value while all others will be quite unreasonable or even negative. See example below. An IRR ignores the size of the project completely. See example below. Each of the two rules used for making capital-budgeting decisions has its strengths and weaknesses. The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use when allocating capital. Common assumption in both the methods is that cash flows occur at the end of the year. However other assumptions differ as shown below. Assumptions in NPV method Requires an assumption of discount rate. Hurdle rate, discount rate, RRR are common surrogates. Assumes that the discount rate will be constant over the period of the project. If not, NPV method should discount the cash flows at different discount rates in different periods. Assumes that the project cash flows are reinvested at the discount rate. In the real world, those assumptions can break down, particularly in periods when interest rates are fluctuating. Assumptions in IRR method Assumes validity of single discount rate (IRR) over the project tenure in analysis. This may not be true actually. Assumes that cash flows are reinvested at IRR.