In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.
All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment.
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 1% and 12% 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. 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.
The advantage to using the NPV method over IRR is the above example 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.
Another situation that causes problems for users of 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.
So, why is the IRR method still commonly used in capital budgeting? Its popularity is probably a direct result of its reporting simplicity. 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.
The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, 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 an effective measurement.