In this blog, I will delve into the key reasons why is NPV better than IRR | NPV VS IRR, explaining both concepts in detail and using real-world examples to demonstrate how NPV avoids the pitfalls associated with IRR. By the end, you’ll understand why leading financial analysts and businesses favor NPV when making crucial investment decisions. Let’s get started!
Before reading the blog, you’ll have to understand the basic differences between NPV and IRR
Difference Between NPV and IRR
NPV (Net Present Value)
Definition: NPV is a financial metric that calculates the value of a project or investment by considering the present value of its expected cash flows minus the initial investment.
Key Points:
- How it Works: It discounts future cash flows back to their present value using a specific rate (often the cost of capital).
- Decision Rule: If NPV is greater than 0, the investment is considered good; if it’s less than 0, it’s not a good choice.
- Focus: It tells you how much value the project adds to today’s money.
In the blog “How to Calculate Net Present Value (NPV)” I’ve explained the full method of NPV calculations and its decision criteria.
IRR (Internal Rate of Return)
Definition: IRR is the rate at which the NPV of a project becomes zero. In other words, it’s the discount rate that makes the present value of future cash flows equal to the initial investment.
Key Points:
- How it Works: It helps find the break-even point for the investment.
- Decision Rule: If the IRR is greater than the required rate of return (or cost of capital), the investment is considered good.
- Focus: It gives you a percentage that shows the profitability of the investment.
In the blog “How to Calculate Internal Rate of Return (IRR)” I’ve explained the full method of IRR calculation and its decision criteria.
Summary of Differences between NPV and IRR
- Purpose: NPV gives a dollar value, while IRR gives a percentage.
- Interpretation: NPV tells you how much money you’ll make; IRR tells you the rate of return you can expect.
- Decision Making: NPV is more straightforward for evaluating profitability, while IRR can sometimes be misleading, especially with projects that have varying cash flows.
In the world of corporate finance and investment decision-making, choosing the right project evaluation method is crucial for a company’s success. When a business considers investing in a new project, expansion, or any major capital expenditure, understanding the financial viability of that investment is essential. Two of the most commonly used methods for evaluating the profitability of such investments are Net Present Value (NPV) and Internal Rate of Return (IRR).
While both methods are valuable tools in their own right, they differ significantly in how they assess a project’s profitability, and relying solely on one method over the other can lead to suboptimal decisions.
Many finance professionals still debate which method provides a clearer, more accurate picture of a project’s true value. In practice, NPV is often regarded as the superior method for making well-informed financial decisions. Yet, many companies still default to using IRR, due to its simplicity and the allure of a percentage-based return that seems easier to interpret.
However, this simplicity can be deceiving. IRR often leads to misleading results, especially when comparing projects of different sizes, when cash flows are unconventional, or when the reinvestment assumptions are unrealistic. On the other hand, NPV provides a more reliable measure of a project’s contribution to shareholder wealth by focusing on how much value a project adds in absolute dollar terms. It accounts for the time value of money, risk, and realistic reinvestment assumptions, giving decision-makers a clearer picture of whether a project will enhance the firm’s financial position.
Six basic reasons why is NPV better than IRR, you must know
1. Focus on Actual Value Added:
NPV tells you how much actual dollar value a project will add to the company, while IRR only focuses on the rate of return, which may not reflect the true value.
Example: A company is deciding between two projects. Project A promises a 30% IRR and generates 5,000 dollars in value, while Project B promises a 20% IRR but generates 100,000 dollars in value.
Explanation: IRR might make Project A look better due to its higher return percentage, but NPV clearly shows that Project B adds far more actual value to the company (100,000 dollars vs. 5,000 dollars ). NPV provides a more meaningful number by showing the dollar value added, which IRR ignores.
2. Handling of Different Project Sizes:
NPV gives a clearer picture of which project brings more value, even when the projects are of different sizes. IRR might favor smaller projects with higher rates of return but lower overall cash generation.
Example: Project X requires a 10,000 dollars investment and gives a 50% return, while Project Y requires a $500,000 investment and gives a 15% return.
Explanation: IRR favors Project X because of its high percentage return, but NPV shows that Project Y generates much more value due to its larger size. Even though Project Y’s IRR is lower, the absolute profit is significantly higher, which NPV captures.
3. Reinvestment Rate Assumptions:
NPV assumes cash flows are reinvested at the firm’s cost of capital (WACC), which is a realistic assumption. IRR assumes reinvestment at the same high rate of return, which is often unrealistic.
Example: A project with a 40% IRR assumes that all cash flows are reinvested at 40%. But realistically, the company can only reinvest cash at its 10% cost of capital (WACC).
Explanation: NPV assumes reinvestment at the realistic WACC (10%), while IRR makes an unrealistic assumption that cash flows can keep earning 40%. This can lead to overestimating a project’s profitability using IRR, whereas NPV gives a more grounded assessment.
4. Multiple IRRs Problem:
Some projects can have more than one IRR, especially when cash flows change direction (positive to negative or vice versa) more than once. This creates confusion, but NPV avoids this issue entirely by focusing on value.
Example: A project has an initial outflow of 50,000 dollars, a positive inflow of 100,000 dollars, and then a negative cash flow of 20,000 dollars. This gives two IRRs: 10% and 50%.
Explanation: Having multiple IRRs can create confusion, as it’s unclear which rate to use for decision-making. NPV avoids this problem entirely, as it provides one clear value that reflects the project’s true worth.
5. Clearer Decision Making for Mutually Exclusive Projects:
When choosing between mutually exclusive projects, NPV clearly shows which project adds more value, whereas IRR might lead to wrong choices if the rates of return differ greatly but the actual cash generated is not as high.
Example: A company can invest in either Project A or Project B but not both. Project A has an IRR of 30% and adds 50,000 dollars in value, while Project B has an IRR of 25% but adds 150,000 dollars in value.
Explanation: NPV shows that Project B is the better choice because it adds more value (150,000 dollars vs. 50,000 dollars), even though its IRR is lower. IRR might mistakenly lead to choosing Project A due to the higher percentage, but NPV focuses on total value added.
6. No Ambiguity:
NPV provides a single, definitive value for whether a project should be accepted or rejected, while IRR can sometimes offer multiple or confusing results, especially in non-normal cash flow situations.
Example: A project has irregular cash flows, leading to an IRR of 10% in one case and 100% in another due to cash flow patterns.
Explanation: IRR’s multiple possible values create ambiguity. NPV, however, provides a single, clear value that indicates whether the project should be accepted or rejected, making it easier for decision-makers to move forward without confusion.
These are mainly the basic reasons, why is NPV better than IRR.
Let me know in the comment box if you’re still confused regarding any point.
