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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.

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