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

    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).
  2. 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.
  3. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  4. Investing

    Private Equity on Steroids: How Debt Fuels Outsized Returns

    Hot Air: Many private equity firms use a legal technique that can boost returns by 25% or more, Bloomberg says
  5. 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.
  6. Investing

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    The DCF method can be difficult to apply to real-life valuations. Find out where it comes up short.
  7. Small Business

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
Hot Definitions
  1. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  2. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  3. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  4. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  5. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  6. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
Trading Center