IRR Or NPV- Decisions Budgeting


Which method do you think is the better one for making capital budgeting decisions - IRR or NPV


IRR is the interest rate at which the NPV is zero, so both are related to each other. Expert says that NPV is better due to 100% accurate all the time. On opposite IRR present short term projects to be more attractive and also make projects with a negative NPV look attractive and vice versa. When all other finding to be equal utilizing the internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often gives the same findings. In number of projects using IRR is not as effective as using NPV to discount cash flows. IRR's major limitation can also be present as its greatest strength of using one single discount rate to evaluate every investment.

When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate sometimes very significantly the annual equivalent return from the project. The formula considers that the company posse’s different projects, with having attractive prospects, in which to invest the interim cash flow. In this case, the calculation implicitly takes credit for these additional projects. In opposite way the calculations of net present value (NPV), consider that a company can earn its cost of capital on interim cash flows, leaving any future incremental project value with those future projects.

Without any change, IRR does not entertain the changing discount rates that make it inadequate for longer-term projects having discount rates that are likely to change with time. Another type of project for which a basic IRR calculation is inappropriate is a project having a mixture of multiple positive and negative cash flows. The situation that creates problems in using the IRR method is the situation when the discount rate of a project is not known.

References

Internal rate of return  Computerworld. Framingham, Feb 17, 2003, Gary H Anthes.
Dudley, C. L. (1972). A note on reinvestment assumptions in choosing between net present value and internal rate of return. The Journal of Finance, 27(4), 907-915.
Brealey, R. A., Myers, S. C., & Allen, F. (2006). Corporate finance (Vol. 8). Boston et al.: McGraw-Hill/Irwin.

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