Comparison of npv with irr

CAPITAL BUDGETING: COMPARISON OF NPV WITH IRR

1. Comparison of NPV with IRR The Net present value and the Internal rate of return methods are closely related investment criteria. Both are time adjusted methods of measuring investment worth. In case of independent projects, two methods lead to same decision. However, under certain situations, a conflict arises between them. It is under this case that a choice between the two criteria has to be made.

2. Difference between NPV and IRR NPV Net Present value (NPV) discounts the stream of expected cash flows associated with a proposed project to their current value, which presents a cash surplus or loss for the project. IRR The Internal Rate of Return (IRR) calculates the percentage rate at which those same cash flows result in a Net Present V alue of Zero.

3. Difference between NPV and IRR Purpose : The NPV Method focuses on project surpluses .While the IRR Method focuses on the breakeven cash flow of a project. Expressed in : NPV is expressed in Absolute terms. Whereas IRR is expressed in percentage terms. Variation in the cash outflow timing : In case of NPV it will not affect the Net present value. But in case if IRR, it will show negative or multiple IRR. Decision Making: Decision making is easy in Net present value but not in IRR.

4. Difference between NPV and IRR NPV of projects can be added. For example, NPV (A+B) = NPV (A) + NPV (B). This is called the value additivity principle. It implies that if we know the NPVs of individual project , the value of the firm will increase by sum of their NPVs Unlike in case of the NPV method, the value additivity principle does not hold when the IRR method is used- IRR of the project do not add . Thus for project A and B, IRR(A) + IRR (B) need not to be equal to IRR (A+B). Value Additivity

5. Similarities Between NPV and IRR Both are the modern techniques of capital budgeting. Both are considering the time value for money. Both takes into consideration the cash flow throughout the life of the project. In case of conventional independent projects: Conventional investment proposals which involve cash outflows in the initial period followed by a series of cash inflows. In case of conventional investments, which are economically independent of each other, NPV and IRR methods results in same accept or reject decision if the firm is not constrained for funds in accepting all profitable projects Example of conventional investment is lending and borrowing type projects.

6. Conflicts between NPV and IRR

7. Investment projects are said to be mutually exclusive when one investment is to be accepted and other would have to be excluded. On the other hand, two independent projects may also be mutually exclusive if a financial constraint is imposed. The NPV and IRR will give conflicting ranking to mutually exclusive projects. In the case of independent project, ranking is not important since all the profitable projects will be accepted. Ranking of projects, however become crucial in case of mutually exclusive projects. Since the NPV and IRR rule can give conflicting ranking to projects, one cannot remain indifferent as to the choice of rule. In case of Mutually Exclusive Projects

8. The NPV and IRR give conflicting ranking to the projects under the following conditions: The cash flow pattern of the projects may differ The cash outlay (initial investments ) of projects may differ The projects may have different expected lives.

9. Timing of Cash Flows: The most commonly found condition for the conflict between the NPV and IRR methods is the difference in the timing of cash flows. Scale of Investment: Another condition under which the NPV and IRR methods will give contradictory ranking to the projects is when cash outlays are of different sizes.

10. Project Life span: Difference in the life span of two mutually exclusive projects can also give rise to the conflicts between NPV and IRR rules.

11. CONCLUSION As we can conclude that if you are evaluating two or more mutually exclusive projects or when there is a conflict between NPV and IRR method, so its choose NPV method instead of IRR method. Incremental approach has also proved the preferability of IRR method. It is safe to depend on NPV method for selecting the best investment plan due to its realistic assumptions & better measure of profitability. Also, NPV is better than IRR because a positive NPV indicates addition to shareholder’s wealth and negative indicates vice versa.