CFA Level 1
Corporate Finance - Advantages and Disadvantages of the NPV and IRR Methods
While useful NPV and IRR methods are useful methods for determining whether to accept a project, both have their advantages and disadvantages.
Advantages:
- With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
- With the IRR method, the advantage is that it shows the return on the original money invested.
Disadvantages:
- With the NPV method, the disadvantage is that the project size is not measured.
- With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below.
The Multiple IRR Problem
A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital).
This is known as a "non-normal cash flow", and such cash flows will give multiple IRRs.
Why Do NPV and IRR Methods Produce Conflicting Rankings?
When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project.
While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes.
A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital).
This is known as a "non-normal cash flow", and such cash flows will give multiple IRRs.
Why Do NPV and IRR Methods Produce Conflicting Rankings?
When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project.
While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes.
Look Out! The timing of cash flows as well as project sizes can produce conflicting results in the NPV and IRR methods. |
Example: NPV and IRR Analysis
Assume once again that Newco needs to purchase a new machine for its manufacturing plant. Newco has narrowed it down to two machines that meet its criteria (Machine A and Machine B), and now it has to choose one of the machines to purchase. Further, Newco has assumed the following analysis on which to base its decision:
Figure 11.6: Potential Machines for Newco
Answer:
We first determine the NPV for each machine as follows:
NPV_{A} = ($5,000) + $2,768 + $2.553 = $321
NPV_{B }= ($10,000) + $5,350 + $5,106 = $456
According to the NPV analysis alone, Machine B is the most appropriate choice for Newco to purchase.
The next step is to determine the IRR for each machine using our financial calculator. The IRR for Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%.
According to the IRR analysis alone, Machine A is the most appropriate choice for Newco to purchase.
The NPV and IRR analysis for these two projects give us conflicting results. This is most likely due to the timing of the cash flows for each project as well as the size differential between the two projects.
The Post-Audit's Role
The post-audit process in the capital-budgeting process is quite important. In the post-audit process, an analyst examines a company's capital-budgeting decisions to see how the actual results from the projects compare to the results the company estimated. The post-audit process gives the company a sense of not only how the projects are performing, but also how good its inputs were.
If a project's actual results differed significantly in a negative direction, the post-audit process will help the company learn where it went wrong with respect to inputs so that the same mistake will not be made when analyzing future projects.
We first determine the NPV for each machine as follows:
NPV_{A} = ($5,000) + $2,768 + $2.553 = $321
NPV_{B }= ($10,000) + $5,350 + $5,106 = $456
According to the NPV analysis alone, Machine B is the most appropriate choice for Newco to purchase.
The next step is to determine the IRR for each machine using our financial calculator. The IRR for Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%.
According to the IRR analysis alone, Machine A is the most appropriate choice for Newco to purchase.
The NPV and IRR analysis for these two projects give us conflicting results. This is most likely due to the timing of the cash flows for each project as well as the size differential between the two projects.
The Post-Audit's Role
The post-audit process in the capital-budgeting process is quite important. In the post-audit process, an analyst examines a company's capital-budgeting decisions to see how the actual results from the projects compare to the results the company estimated. The post-audit process gives the company a sense of not only how the projects are performing, but also how good its inputs were.
If a project's actual results differed significantly in a negative direction, the post-audit process will help the company learn where it went wrong with respect to inputs so that the same mistake will not be made when analyzing future projects.
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