In capital budgeting, there are a number of different approaches that can be used to evaluate a project. Each approach has its own distinct advantages and disadvantages. Most managers and executives like methods that look at a company's capital budgeting and performance expressed in percentages rather than dollar figures. In these cases, they tend to prefer using IRR or the internal rate of return instead of the NPV or net present value. But using IRR may not produce the most desirable results.
Here, we discuss the differences between the two and what makes one preferable over the other.
What Is IRR?
IRR stands for internal rate of return. When used, it estimates the profitability of potential investments using a percentage value rather than a dollar amount. It is also referred to as the discounted flow rate of return or the economic rate of return. It excludes outside factors such as capital costs and inflation.
The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. A company may want to go ahead with a project if the IRR is calculated to be more than the company's required rate of return or it shows a net gain over a period of time. On the other hand, a company may want to reject a project if it falls below that rate or return or it projects a loss over a period of time.
The result is usually simple, which is why it is still commonly used in capital budgeting. But for any project that is long-term, that has multiple cash flows at different discount rates or that has uncertain cash flows—in fact, for almost any project at all—IRR isn't always an effective measurement. That's where NPV comes in.
What Is NPV?
Unlike the IRR, a company's NPV, or net present value, is expressed in a dollar figure. It is the difference between a company's present value of cash inflows and its present value of cash outflows over a specific period of time.
NPV estimates a company's future cash flows of the project. It then discounts them into present value amounts using a discount rate representing the project's capital costs as well as its risk. The investment's future positive cash flows are then reduced into a single present value figure. This number is deducted from the initial amount of cash needed for the investment. In short, the net present value is the difference between the project cost and the income it generates.
The NPV method is inherently complex and requires assumptions at each stage such as the discount rate or the likelihood of receiving the cash payment.
Problems with IRR
Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between around 0.1% and 6.4% in the last 20 years, so clearly the discount rate is changing.
Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with discount rates that are expected to vary.
Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which the marketing department must reinvent the brand every couple of years to stay current in a trendy market.
Capital Budgeting: Which is Better, IRR or NPV?
The project has cash flows of:
- Year 1 = -$50,000 (initial capital outlay)
- Year 2 = $115,000 return
- Year 3 = -$66,000 in new marketing costs to revise the look of the project.
A single IRR can't be used in this case. Recall that IRR is the discount rate or the interest needed for the project to break even given the initial investment. If market conditions change over the years, this project can have multiple IRRs. In other words, long projects with fluctuating cash flows and additional investments of capital may have multiple distinct IRR values.
Another situation that causes problems for people who prefer the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible. If it is below, the project is considered not doable. If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it's considered to be financially worthwhile.
The advantage to using the NPV method over IRR using the example above is that NPV can handle multiple discount rates without any problems. Each year's cash flow can be discounted separately from the others making NPV the better method.
The NPV can be used to determine whether an investment such as a project, merger or acquisition will add value to a company. Positive net values mean they shareholders will be happy, while negative values are not so beneficial.
The Bottom Line
Both IRR and NPV can be used to determine how desirable a project will be and whether it will add value to the company. While one uses a percentage, the other is expressed as a dollar figure. While some prefer using IRR as a measure of capital budgeting, it does come with problems because it doesn't take into account changing factors such as different discount rates. In these cases, using the net present value would be more beneficial.