Internal Rate of Return (IRR) and Net Present Value (NPV)
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Internal Rate of Return (IRR) and Net Present Value (NPV) are both powerful tools used in business to determine whether or not to invest in a particular project; both methods have its pros and cons. If given a choice I would choose NPV, because of the potential to anticipate profitability.
As it is assumed that the objective of a firm is to create as much shareholder wealth as possible for its owners through the efficient use of resources, the preferred method in determining whether or not to invest in a project is NPV. The reason for this is that NPV takes into account all the costs and benefits of an investment opportunity, making a logical allowance for the time factor. Generally speaking any appraisal that returns a positive NPV result is a worthwhile investment. This means finding the NPV of a business will have a direct bearing on shareholder wealth. Net present value is a way of comparing the value of money now with the value of money in the future. A dollar today is worth more than a dollar in the future, because inflation erodes the buying power of the future money, while money available today can be invested and grow.
There are two advantages NPV as a capital expenditure appraisal technique it accurately recognizes the time value of money for all expenditures, regardless of the exact time at which they are made or received it enables alternative proposals to be ranked in order of attractiveness it recognizes the time value of money by converting future expenditures and receipts to their corresponding present value on investment criteria, taking account of the exact date on which they are expected to be made or received.
There are two disadvantages to NPV as a method of appraising capital expenditure proposals the net present value requires the organization to calculate an interest rate to use for appraising capital investment proposals; the net present value calculation is only valid for the interest rate that has been used; the interest rate that is used is usually the organization’s Cost of Capital. But this Cost of Capital can change and can be subject to disagreement. The NPV calculation is only valid for the interest rate that has been used. If an organization has appraised its capital investment proposals using one interest rate it will have a series of ‘go’ or ‘no go’ decisions which will only be valid for that interest rate. If the interest rate rises or falls, the decisions will no longer be valid; the calculations will have to be re-worked and new decisions taken.
IRR is the flip side of NPV and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company’s cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV (and should be made) and above which an investment results in a negative NPV (and should be avoided). It’s the breakeven discount rate, the rate at which the value of cash outflows equals the value of cash inflows. One can appreciate the problems of this method when we consider appraising several projects alongside each other. IRR is the exposure of future earnings and capital to interest rate changes. Interest rate fluctuations affect earnings by changing net interest income and other interest-sensitive income.
Firstly, it is popular because of its simplicity. Research over the years has shown that firms favor it and perhaps this is understandable given how easy it is to calculate. Secondly, in a business environment of rapid technological change, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential. Thirdly, the investment climate demands that investors are rewarded with fast returns. Many profitable opportunities for long-term investment are overlooked because they involve a longer wait for revenues to flow.
IRR The payback period is the most widely used technique and is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. IRR is often used as an initial screening method. It lacks objectivity. Who decides the length of the optimal payback time? No one does – it is decided by pitting one investment opportunity against another. IRR takes no account of the effect on business profitability. Its sole concern is cash flow.
Despite the disadvantage discussed above, NPV is the single most valuable of the various methods of capital investment appraisal and the one that should be used as the basis of decision making in this area. It is probably best to see payback as a measure of liquidity than profitability. On that basis the IRR method should only be a preliminary screening device, which is inappropriate as a basis for sophisticated investment decisions.