Next video:
Loading the player...

Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.

IRR uses one discount rate, which is OK when evaluating projects that share a common discount rate, predicable cash flows, equal risk, and a shorter time horizon. But discount rates usually change over time. IRR does not account for changes, making it a poor option for longer-term projects with varying discount rates.

IRR calculations are also ineffective for projects with a mix of positive and negative cash flows. Consider a marketing project that must be updated every couple of years to remain current. Its cash flows are negative $50,000 in Year 1 due to the initial outlay. It returns $115,000 in Year 2, and costs $66,000 in Year 3 when the project receives a new look. NPV can discount each cash flow separately, making it a better option.

Using NPV also works better when a project’s discount rate is not known. The IRR has to be compared to the discount rate to gauge a project’s feasibility. If the IRR is higher than the discount rate, it’s a good project to pursue. If a project’s NPV is above zero, it’s financially worthwhile.

  1. No results found.
Related Articles
  1. Investing

    Internal Rate of Return: An Inside Look

    Use this method to choose which project or investment is right for you.
  2. Investing

    Return on Investment (ROI) Vs. Internal Rate of Return (IRR)

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  3. Small Business

    Calculating the Internal Rate of Return Using Excel

    The internal rate of return on investments is explained and illustrated in different investment scenarios.
  4. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  5. Managing Wealth

    What's a Hurdle Rate?

    Hurdle rate has two meanings. In the business world, a business typically makes a decision on a capital project based on the net present value approach. To determine the net present value, the ...
  6. Small Business

    Modified Internal Rate of Return (MIRR)

    Modified internal rate of return (MIRR) is a variant of the more traditional internal rate of return calculation.
  7. Small Business

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
Hot Definitions
  1. Fiat Money

    Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat ...
  2. Investing

    The act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit.
  3. Stagflation

    A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, ...
  4. Notional Value

    The total value of a leveraged position's assets. This term is commonly used in the options, futures and currency markets ...
  5. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. ...
  6. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
Trading Center