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Meaning of NPV

NPV is a technique of Capital Budgeting used to analyze the profitability of a project. It is


the difference between the present value of cash inflows & present value of cash outflows.

Advantages of NPV

 NPV is a direct measure of contribution.


 It reveals the net worth & wealth of shareholders
 It takes into consideration all the cash flows
 It takes into consideration time value of money
 Considers the risk of future cash flows
 Provide better forecast

Properties of Net Present Value

 Higher income amounts make NPV higher


 If profits comes sooner NPV is higher
 Changing discount rates changes the value of NPV

Meaning of IRR

IRR on a project is the annualized effective compounded rate of return that makes NPV of
all cash flows from a particular investment equals to zero

Advantages of IRR

 IRR indicates rate of return of a project


 It shows the return on original money invested
 It tells whether the investment will increase firm’s value
 It calculates the break even
 IRR calculates an alternative cost of capital including an appropriate risk premium

Superiority of NPV over IRR

In capital budgeting, there are a number of different approaches that can be used to
evaluate any given project, and each approach has its own distinct advantages and
disadvantages.
Net present value is an absolute measure i.e. it represents 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 a project offers over its lifespan.
NPV and IRR are two of the most widely used investment analysis and capital budgeting
decision tools. Both are discounting models i.e. they take into account the time value of
money phenomena. However, each method has its strengths and weaknesses and there are
situations in which they do not agree on the ranking of acceptability of projects. For
example, there might be a situation in which project A has higher NPV but lower IRR than
project B. This NPV and IRR conflict depends on whether the projects are independent or
mutually exclusive.

Independent Projects

Independent projects are projects in which decision regarding acceptance of one project
does not affect decision regarding others.
Since all independent projects can all be accepted if they add value, NPV and IRR conflict
doesn’t arise. The company can accept all projects with positive NPV.

Mutually Exclusive Projects

(Answer to question –Project A better than B with respect to NPV & Project B better than A as
per IRR)

Mutually exclusive projects are projects in which acceptance of one project excludes the
others from consideration. In such a scenario the best project is accepted. NPV and IRR
conflict, which can sometimes arise in case of mutually exclusive projects, becomes critical.
The conflict either arises due to the relative size of the project or due to the different cash
flow distribution of the projects.
Since NPV is an absolute measure, it will rank a project adding more dollar value higher
regardless of the original investment required. IRR is a relative measure, and it will rank
projects offering best investment return higher regardless of the total value added.

Example

Project A requires $10 million investments and generates $10 million each in year 1 and
year 2. It has NPV of $7.4 million @ 10% discount rate and IRR of 61.8%. Project B requires
$1 million investment and generates $2 million in Year 1 and $1 million in Year 2. Its NPV
@ 10% and IRR turn out to be $1.6 million and 141.4%. Based on NPV one would conclude
that Project A is better, but IRR offers a contradictory view. This conflict arose mainly due
to the size of the project.
NPV vs IRR conflict also arises due to the different cash flow distribution. IRR inherently
assumes that any cash flows can be reinvested at the IRR. This assumption is unrealistic
because there is no guarantee that reinvestment at IRR can be achieved. NPV on the other
hand assumes reinvestment at the cost of capital, which is conservative and realistic.
Example

Let’s consider two projects: A and B, both require $10 million investment each. Project A
generates $15 million in Year 1 and $10 million in Year 2. Project B generates 0 in Year 1
and $30 million in Year 2. You can verify that Project A has NPV of $11.9 million at 10%
discount rate and IRR of 100%. Project has NPV of $14.8 million and IRR of 73.2%. Despite
both having the same initial investment, NPV is higher for Project B while IRR is higher for
Project B. This is because in case of Project A more cash flows are in Year 1 resulting in
longer reinvestment periods at higher reinvestment assumption and hence higher IRR. NPV
is not affected by reinvestment assumption.

Comparison of strengths and weaknesses

NPV is theoretically sound because it has realistic reinvestment assumption. It considers


the cost of capital and provides a dollar value estimate of value added, which is easier to
understand.
Another very important feature of NPV analysis is its ability to notch the discount rate up
and down to allow for different risk level of projects.
However, NPV is dependent on the size of the project. Without careful analysis, an investor
might select a high NPV project ignoring the fact that many smaller NPV projects could be
completed with the same investment resulting in higher aggregate NPV. It requires careful
analysis in capital rationing.
IRR is not affected by the size of the project. 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. This feature
makes it a good complement to NPV.
IRR is also easier to calculate because it doesn’t require estimation of cost of capital or
hurdle rate. It just requires the initial investment and cash flows. However, this same
convenience can become a disadvantage if projects are accepted without comparison to
cost of capital.
However, IRR’s assumption of reinvestment at IRR is unrealistic and could result in
inaccurate ranking of projects. Another, quite serious weakness is the multiple IRR
problem . 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.

Conclusion

Whenever there is a conflict in ranking of projects based on NPV and IRR, it is safer to
always prefer the NPV ranking. This is due to the realistic assumption and theoretical
soundness of the method.
However, IRR is a great complement to NPV. It helps see a more complete picture.