Net Present Value versus Internal Rate of Return
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Both net present value (NPV) and the internal rate of return (IRR) incorporate the same data and utilize the equal time value of money theory in their computations. Given this, why is the net present worth considered to be a superior measure when making capital budgeting decisions? Explain.
Capital budgeting is a critical stage in investment appraisal, and the most common techniques used in this stage are Net Present Value (NPV) and Internal Rate of Return (IRR). NPV entails evaluation of the value yielded by an investment by subtracting the cost from the value of a project. IRR evaluates the rate of return of an investment and is the value that zeroes the NPV. Despite both NPV and IRR using the same data and time value theory of money, the NPV is the most popular technique Baker et al. (2011). The high preference of NPV over IRR, as discovered in Canada, can be attributed to the following factors.
Firstly, the application of IRR is impossible in gauging mutually exclusive projects. Mutually exclusive plans are projects in which the selection of one project rules out the other. For such projects, the NPV of one project may be higher than the other while the IRR of the other project may be higher. The decision rules state that the projects with the highest NPV and the highest IRR should be selected hence a dilemma. However, the maxim of decision making in capital budgeting is, in times of clash between NPV and another decision rule, always use the NPV. Therefore NPV is made superior to IRR.
Secondly, the IRR cannot be used effectively in a case of uncustomary cash flows as compared to NPV. The NPV is capable of adapting to changes in cash flow. However, for IRR, changes in cash flows lead to different returns. Decision making is hard because of the various IRR. In such a scenario, the NPV is considered more reliable than IRR.
Thirdly, NPV accounts for changes in discount rates over time. NPV can handle different discount rates over various periods more effectively than IRR. Calculating the IRR is based on trial and error method. The simplicity of the IRR makes it unfit in analyzing long term projects. The consideration of changing factors like inflation that affect interest rates makes NPV more preferred than IRR.
Evidence from firms in Canada suggests that NPV has a high preference over IRR. Although both NPV and IRR have similarities in data and time value theory of money, NPV is superior. IRR cannot be used to assess mutually exclusive projects hence the application of NPV. NPV is capable of handling a variety of cash flows as compared to IRR that can only handle normal cash flows. Unlike IRR, the NPV accounts for changes in discount rates and is more effective in evaluating long-term projects.
Reply to other work
I fully concur with the work by Charlene since it suggests that NPV is superior to IRR. The work notes that IRR fails to account for factors that are likely to change. An example of such factors is the discounted rates. The work further concludes that IRR is not easily applicable in analyzing long-term projects because of the mix of positive and negative cash flows. The work realizes that NPV is capable of handling multiple discount rates. I find the work consistent with my work and congruous with earlier studies.
References
Kent Baker et al. (2011). Corporate Finance Practices in Canada: Where Do We Stand? Multinational Finance Journal, 157-192.