NPV vs IRR
The net present value (NPV) and the internal rate of return (IRR) could as well be defined as two faces of the same coin as both reflect on the anticipated performance of a firm or business over a particular period of time. The main difference however should be more evident in the method or should I say the units used. While NPV is calculated in cash, the IRR is a percentage value expected in return from a capital project.
Due to the fact that NPV is calculated in currency, it always seems to resonate more easily with the general public as the general public comprehends monetary value better as compared to other values. This does not necessarily mean that the NPV is automatically the best option when evaluating a firm’s progress. The best option would depend on the perception of the individual doing the calculation, as well as, his objective in the whole exercise. It is evident that managers and administrators would prefer the IRR as a method, as percentages give a better outlook that can be used to make strategic decisions over the firm.
Another major shortfall associated with the IRR method is the fact that it cannot be conclusively used in circumstances where the cash flow is inconsistent. While working out figures in such fluctuating circumstances may prove tricky for the IRR method, it would pose no challenge for the NPV method since all that it would take is the collection of all the inflows-outflows and finding an average over the entire period in focus.
Evaluating the viability of a project using the IRR method could cloud the true picture if the figures on the inflow and outflow remain to fluctuate persistently. It may even give the false impression that a short term venture with high return in a short time is more viable as compared to a bigger long-term venture that would otherwise make more profits.
In order to make a decision between any of the two methods, it is important to take note of the following significant differences.
Summary:
1. While the NPV will work better in helping other people such as investors in understanding the actual figures in so far as the evaluation of a project is concerned, the IRR will give percentages which can be better understood by managers
2. As much as discrepancies in discounts will most likely lead to similar recommendations from both methods, it is important to note that the NPV method can evaluate big long-term projects better as opposed to the IRR which gives better accuracy on short term projects with consistent inflow or outflow figures.
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Reg NPV vs IRR, I am pleased to attach links to three of my recent papers on CBA and investment project appraisal:
1. “A New Method to Estimate NPV from the Capital Amortization Schedule and an Insight into Why NPV is Not the Appropriate Criterion for Capital Investment Decision”. paper link: http://ssrn.com/abstract=2899648.
This paper introduces a new method to estimate the NPV based on Capital Amortization Schedule (CAS) and not the conventional DCF method. The new method is more transparent. This paper questions the validity of the NPV as a preferred criterion than IRR. The results also clarify that there is no reinvestment of intermediate income, as CAS does not involve reinvestment. When there is no reinvestment, the MIRR estimate is also redundant.
2. IRR Performs Better than NPV: A Critical Analysis of Cases of Multiple IRR and Mutually Exclusive and Independent Investment Projects. https://ssrn.com/abstract=2913905
3. The Controversial Reinvestment Assumption in IRR and NPV Estimates: New Evidence Against Reinvestment Assumption (February 16, 2017). https://ssrn.com/abstract=2918744
These papers present evidence to identify the most appropriate investment criterion (IRR vs NPV) with emphasis on the controversial multiple, negative and no IRR, mutually exclusive investment and independent projects. The analysis is based on the estimated return on capital (ROC), return on invested capital (ROIC) and capital amortization schedule (CAS). Numerical evidence is furnished to recommend IRR as the best criterion and not the NPV.
The analytical results presented in these papers question some of the conventional wisdoms advocated by most finance and economic texts or project analysis guide or publications or teaching materials and therefore the contents will enable the respective authors or organization to revise or update their publications accordingly. The current practice is to prefer NPV but the evidence does not support such preference.
Obviously, without perfecting the methods any amount of skill-full analysis and articulation may not add value and credibility. Please feel free to send me your comments.
Regards
Dr. Kannan Arjunan
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