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In capital budgeting, there are a number of different approaches that can be used to evaluate a project. Two very common methodologies of evaluating a project are the internal rate of return and net present value. However, each approach has its own distinct advantages and disadvantages. Here, we discuss the differences between the two and the situations where one method is preferable over the other.
The internal rate of return (IRR) estimates the profitability of potential investments using a percentage value rather than a dollar amount. It is also referred to as the discounted flow rate of return or the economic rate of return. It excludes external factors such as capital costs and inflation.
The IRR method simplifies projects to a single return percentage that management can use to determine whether or not a project is economically viable. A company often has an internal required rate of return to benchmark against and may decide to move forward with a project if the IRR exceeds this benchmark. On the other hand, a company may want to reject a project if it falls below that rate or return or it projects a loss over a period of time.
The IRR is simple to use and does not require a hurdle or benchmark rate. However, it ignores the size of a project.
Unlike the IRR, a company's net present value (NPV) is expressed in a dollar amount. It is the difference between a company's present value of cash inflows and its present value of cash outflows over a specific period of time.
NPV is calculated by estimating a company's future cash flows related to a project. Then, these cash flows are discounted to present value using a discount rate representing the project's capital costs, risk, and desired rate of return. The sum of all discounted cash flows represents the net present value, and the net present value is the difference between the project cost and the income it generates over time.
NPV is easy to interpret: if the NPV is positive, it is profitable. If the NPV is negative, it is not. However, NPV isn't useful when trying to decide which projects to take on as size or timeline aren't considered.
The primary benefit of IRR is its simplicity: It's easy to calculate and easy to interpret the result. However, there are several drawbacks to this method.
IRR only uses one discount rate, and the true discount rate can change substantially over time - especially if the investment is a long-term project. Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with periods of varying risk or changes in return expectations.
Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which the marketing department must reinvent the brand every couple of years to stay current in a trendy market.
The project has cash flows of:
A single IRR can't be used in this case. Recall that IRR is the discount rate or the interest needed for the project to break even given the initial investment. If market conditions change over the years, this project can have multiple IRRs. In other words, long projects with fluctuating cash flows and additional investments of capital may have multiple distinct IRR values, making it impossible to evaluate.
The IRR method is also problematic when the discount rate of a project is not known. If the IRR is above the discount rate, the project is feasible. If it is below, the project is not. If a discount rate is not known, there is no benchmark to compare the project return against. In cases like this, the NPV method is superior as projects with a positive NPV are considered financially worthwhile.
The advantage to using the NPV method over IRR using the example above is that NPV can handle multiple discount rates or varying cash flow directions. Each year's cash flow can be discounted separately from the others, so the NPV method is more flexible when evaluating individual periods. The NPV method is inherently complex and requires assumptions at each stage such as the discount rate or the likelihood of receiving the cash payment.
The NPV can be used to determine whether an investment such as a project, merger, or acquisition will add value to a company. If an NPV is positive, the sum of discounted cash inflows is greater than the sum of discounted cash outflows. The company will receive more economic benefit than it puts out, so the project, assuming the return is material and no capacity constraints are met, is beneficial to the company.
Alternatively, a negative NPV indicates a company's cash outflows over the life of a project exceed what it is expected to receive. When a project's NPV is negative, the project is not profitable and should not be accepted for financial reasons.
Like the IRR method, there are disadvantages to the NPV method. It may be difficult to determine the required rate of return or discount rate to use to discount cash flow. Also, NPV calculations are biased towards larger projects. One project may have a higher NPV, but its rate of return may be lower, and the total cash outlay may be higher than a smaller project.
IRR and NPV have two different uses within capital budgeting. IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a discount rate. NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.
IRR is calculated by setting the NPV of a series of cash flows to zero and solving for the discount rate. IRR can be solved manually through trial and error, though it is more efficient to leverage software programs to calculate IRR.
NPV is calculated by finding the present value of each cash flow for each period, including any initial cash outflow that occurs immediately. The discount rate used is self-selected as the required rate of return for the project. Once all discounted cash flows have been calculated, add all cash flows to arrive at the net present value.
Both IRR and NPV can be used to determine how desirable a project will be and whether it will add value to the company. While one uses a percentage, the other is expressed as a dollar figure. While some prefer using IRR as a measure of capital budgeting, it does come with problems because it doesn't take into account changing factors such as different discount rates. However, NPV also has limitations such as being unable to compare project sizes or requiring upfront rate estimations.