Two different basic DCF methods have been, NPV and IRR. When used to analyze a project, the decision is easily made:
> If a project has a POSITIVE NPV it should be ACCEPTED
> If a project has an IRR greater than the required rate of return, ACCEPT it
Since the two basic DCF methods are based on the same underlying principle, the time value of money, one would expect them to give identical investment decisions. THIS IS NOT ALWAYS SO four types of investment decision can be identified:
1. Single investment decision
When deciding whether or not to accept a single capital project which based on its conventional cash flow pattern (i.e. cash outflow – cash inflow), a project will be accepted if it has a positive NPV at the required rate of return or its IRR is greater than the required rate of return.
2. Mutually exclusive investments
Organizations may often face decisions in which only one of two or more investments can be undertaken, these are called mutually exclusive investment decisions. In these circumstances NPV and IRR may give conflicting recommendations.
3. Projects with multiple yields
When a project is having non conventional cash flows (cash outflow – cash inflow – cash outflow).
4. Projects without and yield
When a project is having only cash outflow or substantial cash outflow as compare to cash inflow throughout its project life.
Comments:
These are the projects which are always unprofitable but will be least profitable at one particular discount rate.
Conclusion:
- Clearly it is difficult to use the IRR method for decision making in these circumstances due to non-precise or conflicting conclusion provided.
- As a result NPV method is preferred to IRR method because,
a) Absolute and relative measures – the NPV is an absolute measure. but IRR is a relative measure of project viability.
b) Reinvestment assumption – the NPV assumes reinvestment at firm’s cost of capital, IRR assumes reinvestment at the IRR, the NPV’s assumption is comparatively more realistic.
c) Achieving corporate objectives – use of the NPV method is consistent with achieving a firm’s corporate objective of maximizing share price. (i.e. shareholders wealth)
d) Lack of clear guidance for the multiple yields projects, despite having several IRR, projects will have only one NPV at the required rate of return which will be either positive or negative ( or zero ).
Comparison of NPV and IRR
