NPV vs IRR Ranking conflict & the preferred method

Net present value (NPV) and internal rate of return (IRR) are two of the most widely used investment analysis and capital budgeting techniques. They are similar in the sense that both are discounted cash flow models i.e. they incorporate the time value of money. But they also differ in their main approach and their strengths and weaknesses. NPV is an absolute measure i.e. it is the dollar amount of value added or lost by undertaking a project. IRR, on the other hand, is a relative measure i.e. it is the rate of return that a project offers over its lifespan. In such cases, while choosing among mutually exclusive projects, one should always select the project giving the largest positive net present value using appropriate cost of capital or predetermined cut off rate.

See different types of capital budgeting techniques, such as payback period and internal rate of return. (i) Independent investment proposals which do not compete with one another and which may be either accepted or rejected on the basis of a minimum required rate of return. But let’s look further if the cost of capital raised for both projects is 11%. In this instance, the NPV of Project Y is $2,407,063 and Project Z $2,312,414. If the NPV is the only screening criterion, Project Y must be accepted. The problem arises in case of mutually exclusive projects when a company should try to select the best one among others.

What is IRR?

In this case, the two proposals don’t compete, and they are accepted or rejected based on the minimum rate of return on the market. When facing such a situation, the project with a higher NPV should be chosen because there is an inherent reinvestment assumption. In our calculation, there is an assumption that the cash flows will be reinvested at the same discount rate at which they are discounted.

It considers the cost of capital and provides a dollar value estimate of value added, which is easier to understand. Independent projects are projects in which decision about acceptance of one project does not affect decision regarding others. Since we can accept all independent projects if they add value, NPV and IRR conflict does not arise. So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive.

Time Value of Money

The results from NPV show some similarities to the figures obtained from IRR under a similar set of conditions. At the same time, both methods offer contradicting results in cases where the circumstances are different. Under the NPV approach, the present value can be calculated by discounting a project’s future cash flow at predefined rates known as cut off rates. However, under the IRR approach, cash flow is discounted at suitable rates using a trial and error method that equates to a present value.

The present value is calculated to an amount equal to the investment made. If IRR is the preferred method, the discount rate is often not predetermined, as would be the case with NPV. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed.

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In the NPV calculation, the implicit assumption for reinvestment rate is 10%. In IRR, the implicit reinvestment rate assumption is of 29% or 25%. The reinvestment rate of 29% or 25% in IRR is quite unrealistic compared to NPV. IRR is also easier to calculate because it does not need estimation of cost of capital or hurdle rate. However, this same convenience can become a disadvantage if we accept projects without comparison to cost of capital. Conventional proposals often involve a cash outflow during the initial stage and are usually followed by a number of cash inflows.

• (ii) Conventional investment proposals which involve cash outflows or outlays in the initial period followed by a series of cash inflows.
• NPV may lead the project manager or the engineer to accept one project proposal, while the internal rate of return may show the other as the most favorable.
• (iv) The results shown by NPV method are similar to that of IRR method under certain situations, whereas, the two give contradictory results under some other circumstances.

This assumption is problematic because there is no guarantee that equally profitable opportunities will be available as soon as cash flows occur. The risk of receiving cash flows and not having good enough opportunities for reinvestment is called reinvestment risk. NPV, on the other hand, does not suffer from such a problematic assumption because it assumes that reinvestment occurs at the cost of capital, which is conservative and realistic.

Reasons for conflict

The conflict either arises due to relative size of the project or due to the different cash flow distribution of the projects. When faced with difficult situations and a choice must be made between two competing projects, it is best to choose a project with a larger positive net value by using cutoff rate or a fitting cost of capital. 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.

It arrives at the amount to be invested in a given project so that its anticipated earnings would recover the amount invested in the project at market rate. In capital budgeting, NPV and IRR conflict refers to a situation in which the NPV method ranks projects differently from the IRR method. In event of such a difference, a company should accept project(s) with higher NPV. NPV’s predefined cutoff rates are quite reliable compared to IRR when it comes to ranking more than two project proposals. The above example illustrated the conflicting results of NPV and IRR due to differing cash flow patterns. The conflicting results can also occur because of the size and investment of the projects.

Again, if these were mutually exclusive projects, we should choose the one with higher NPV, that is, project B. Now we can see a typical “NPV vs. IRR problem” when those criteria are producing conflicting conclusions. To solve that problem, let’s calculate the NPV at a number of different discount rates to create the graph below. (i) Significant difference in the size (amount) of cash outlays of various proposals under consideration. Such a project exerts a positive effect on the price of shares and the wealth of shareholders.

With NPV, proposals are usually accepted if they have a net positive value. In contrast, IRR is often accepted if the resulting IRR has a higher value compared to the existing cutoff rate. Projects with a positive net present value also show a higher internal rate of return greater than the base value. 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.

This difference could occur because of the different cash flow patterns in the two projects. (iv) The results shown by NPV method are similar to that of IRR method under certain situations, whereas, the two give contradictory results under some other circumstances. However, it must be remembered that NPV method using a predetermined cut -off rate is more reliable than the IRR method for ranking two or more capital investment proposals. Let us make an in-depth study of the difference, similarities and conflicts between Net Present Value (NPV) and Internal Rate of Return (IRR) methods of capital budgeting. However, in case of mutually-exclusive projects, an NPV and IRR conflict may arise in which one project has a higher NPV but the other has higher IRR. Mutually exclusive projects are projects in which acceptance of one project excludes the others from consideration.

Similarities of Outcomes under NPV vs IRR

Actually, NPV is considered the best criterion when ranking investments. NPV takes cognizance of the value of capital cost or the market rate of interest. It obtains the amount that should be invested in a project in order to recover projected earnings at current market rates from the amount invested. It will rank a project requiring initial investment of $1 million and generating $1 million each in Year 1 and Year 2 equal to a project generating $1 in Year 1 and Year 2 each with initial investment of $1.

• As you can see, Project A has higher IRR, while Project B has higher NPV.
• Projects with a positive net present value also show a higher internal rate of return greater than the base value.
• This difference could occur because of the different cash flow patterns in the two projects.
• The above example illustrated the conflicting results of NPV and IRR due to differing cash flow patterns.

In case of non-normal cash flows, i.e. where a project has positive cash flows followed by negative cash flows, IRR has multiple values. NPV stands for Net Present Value, and it represents the positive and negative future conflict between npv and irr cash flows throughout a project’s life cycle discounted today. A company is considering two mutually exclusive projects that are equally risky. Detailed information about cash flows is presented in the table below.

The metric works as a discounting rate that equates NPV of cash flows to zero. Typically, one project may provide a larger IRR, while a rival project may show a higher NPV. The resulting difference may be due to a difference in cash flow between the two projects.

Thus, there is a conflict in ranking of the two mutually exclusive proposals according to the two methods. Under these circumstances, we would suggest to take up Project B which gives a higher net present value because in doing so the firm will be able to maximize the wealth of the shareholders. The reason for similarity of results in the above cases lies in the basis of decision-making in the two methods. Under NPV method, a proposal is accepted if its net present value is positive, whereas, under IRR method it is accepted if the internal rate of return is higher than the cut off rate.

The projects which have positive net present value, obviously, also have an internal rate of return higher than the required rate of return. Thus, the NPV method is more reliable as compared to the IRR method in ranking the mutually exclusive projects. In fact, NPV is the best operational criterion for ranking mutually exclusive investment proposals. In the case of mutually exclusive projects that are competing such that acceptance of either blocks acceptance of the remaining one, NPV and IRR often give contradicting results. NPV may lead the project manager or the engineer to accept one project proposal, while the internal rate of return may show the other as the most favorable. However, IRR’s assumption of reinvestment at IRR is unrealistic and could result in inaccurate ranking of projects.