NPV and IRR are two tools for evaluating projects viability. There have been multiple arguments to find out the best tool between them. Many researchers dating more than a century likes of Dorfman (1981), Fisher (1907) and Boehm-Bawerk(1889) in an article by Osborne have debated on this tool. Brealey, Myers, and Allen (2009) are one of the best authors of the book on corporate finance has always recommended NPV as superior tool rather than IRR because of the deficiency in IRR. However the corporates prefer IRR for easy computation rather than NPV. Fortune 1000 companies prefer the NPV than the IRR. Authors define that IRR yields to multiple solutions, inconsistent ranking where the projects are similar, but the pitfall is taken care by the multiple solution. The concept of Time Value and Money (TVM) splits into IRR and NPV.
NPV is defined as
Where Io is the initial investment in period zero, NPV is net present value, C is the cash flow in period i =1 to n and R being the cost of capital
IRR is defined when NPV becomes 0. Like
After understanding the applicable equations the purpose of this assignment is to understand the better application of both these tools.
Capital investments are long term investments and decision taken by the organization is survive for a longer period. Atrill & McLaney (2011) states that "appraisal of investment in business is necessary, but expensive, still no decision means poor decision making."
Capital budgeting uses many tools like NPV, IRR or Payback period (PP), adjusted present value, discounted payback (Bearly and Mayers, 1996) to find the viability of the project. However NPV and IRR are discussed as easiest tool. Let us look at the problem
OPTION-1
OPTION-2
PV of future cash inflows
5,000
20,000
A
NPV
4,000
10,000
B
IRR
100%
40%
C
PAY BACK PERIOD
1.0
2.5
D
DISCOUNTED PAY BACK PERIOD
1.2
3.8
The solution for the problem needs analysis and detailed understanding of NPV and IRR. In the first option the payback period is only 1 year and the discounted payback period is 1.2 years. The initial investment is very low and the IRR attracts for taking up this project. But the monthly earnings will only be £1000 instead of £4000 in the other project. The accounting rate of return(ARR) in the project 1 is 100% and as per Atrill and McLaney 2011 "ARR takes into consideration of the profits Vs Investment as a percentage" as per this statement the project 1 is viable instead of project 2 because the first project give 100% compared to 40% with lower investment. But this fails to take the monthly return into consideration and the profit cannot be ploughed back in the business. Profits cannot be sustainable in a long run of a business.
When we take Payback Period (PP) into consideration which targets the time into consideration for return on capital which is less in option 1 which is 1 year and discounted payback is 1.2 years where the recovery is speed. In option 2 the recovery is 2.5 years and discounted period is 3.8 years. But PP fails to differentiate between the projects on early payback of capital.
Herbert Kierulff (2008) denotes NPV that it discounts or minimizes the expected future cash inflow from an investment by considering three factors of
Risk of investment
Inflation,
Retention of cash (opportunity lost). NPV is positive then the project is viable.
In this problem Option 1 NPV is £4000 and in option 2 the NPV is £10,000. Accordingly NPV of Project 2 is higher and as per NPV project 2 is viable. NPV also has its own limitations as per Kierulff (2008) a new product cannot be introduced because the reinvestment cost is higher than the capital cost. Secondly a project of unequal size cannot be compared.
IRR is considered with NPV as zero and the yield calculated. Naturally without analysis project 1 is viable than project 2 since it yields 100% compared to 40%. IRR has a ranking problem depending upon the size of the project. Brealey, Myers, and Allen (2006, pp. 95-96) considers ranking as a problem with IRR, and not with NPV. IRR will always exceed the capital cost which is an indicator of investment decision and NPV is positive. But if NPV is negative then the cost of capital is supersedes the IRR.
Depending upon the projects and investment spikes there is necessity of multiple IRR. They may be cumbersome and is confusing. Multiple IRR (MIRR) is gaining popularity but will take a long time in consideration with NPV. MIRR will try to solve the problems NPV and IRR has like
Both NPV and IRR cannot validate spikes in investment.
Risk adjusted Return (RADR) will not be adjusted with risk in the investment funds.
IRR gives multiple rates when cash flow oscillates between negative to positive.
NPV and IRR rank the mutually exclusive projects differently.
There is multiple solution to the problems but it is up to the management to decide on choosing the tool of NPV or IRR. IF IRR is chosen Project 1 is viable, NPV is chosen Project 2 is viable. However NPV being the closely related tool in accounting and capital budgeting project 2 seems to be viable over a period of time. The only constraint being cost of capital at high.
