Complete Guide To Corporate Finance

AAA

Net Present Value And Internal Rate Of Return - Advantages And Disadvantages Of NPV and IRR

Now that you're familiar with both NPV and IRR and understand the shortcomings of PB period and ARR, let's compare the advantages and disadvantages of NPV and IRR. Advantages:

  • The NPV method is a direct measure of the dollar contribution to the stockholders.
  • The IRR method shows the return on the original money invested.

Disadvantages:

  • The NPV method does not measure the project size.
  • The IRR method can, at times, 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 are 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.

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:



We first determine the NPV for each machine as follows:

NPVA = ($5,000) + $2,768 + $2.553 = $321

NPVB = ($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 difference between the two projects.

Profitability Index
comments powered by Disqus
Related Articles
  1. How to Use the Gearing Ratio
    Investing Basics

    How to Use the Gearing Ratio

  2. What's a P&L Statement?
    Investing Basics

    What's a P&L Statement?

  3. How Does Goodwill Affect Financial Statements?
    Investing Basics

    How Does Goodwill Affect Financial Statements?

  4. Using Normal Distribution Formula To ...
    Investing Basics

    Using Normal Distribution Formula To ...

  5. The Government And Risk: A Love-Hate ...
    Insurance

    The Government And Risk: A Love-Hate ...

Trading Center