Subject 1. NPV and IRR

A company should choose those capital investment processes that maximize shareholder wealth.

The net present value (NPV) of an investment is the present value of its cash inflows minus the present value of its cash outflows. The internal rate of return (IRR) is the discount rate that makes net present value equal to 0.

According to the NPV rule, a company should accept projects where the NPV is positive and reject those in which the NPV is negative. A positive NPV suggests that cash inflows outweigh cash outflows on a present value basis. That is, the positive cash flows are sufficient to repay the initial investment along with the capital costs (opportunity cost) associated with the project. If the company must choose between two, mutually-exclusive projects, the one with the higher NPV should be chosen.

According to the IRR Rule, a company should accept projects where the IRR is greater than the discount rate used (WACC) and reject those in which the IRR is less than the discount rate. An IRR greater than the WACC suggests that the project will more than repay the capital costs (opportunity costs) incurred.

There are three problems associated with IRR as a decision rule.

  • Reinvestment

    The IRR is intended to provide a single number that represents the rate of return generated by a capital investment. As such, it is an easy number to interpret and understand. However, calculation of the IRR assumes that all project cash flows can be reinvested to earn a rate of return exactly equal to the IRR itself. In other words, a project with an IRR of 6% assumes that all cash flows can be reinvested to earn exactly 6%. If the cash flows are invested at a rate lower than 6%, the realized return will be less than the IRR. If the cash flows are invested at a rate higher than 6%, the realized return will be greater than the IRR.

  • Scale

    In most cases, NPV and IRR rules provide the same recommendation as to whether to accept or reject a given capital investment project. However, when choosing between two mutually-exclusive projects (ranking), NPV and IRR rules may provide conflicting recommendations. In such cases, the NPV rule's recommendation should take precedence.

    One of the situations in which IRR is likely to contradict NPV is when there are two mutually-exclusive projects of greatly differing scale: one that requires a relatively small investment and returns relatively small cash flows, and another that requires a much larger investment and returns much larger cash flows.

  • Timing

    The other situation in which IRR is likely to contradict NPV is when there are two mutually-exclusive projects whose cash flows are timed very differently: one that receives its largest cash flows early in the project and another that receives its largest cash flows late in the project.

User Contributed Comments 13

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achu: RTS probs of irr : reinvestment, scalability,, timing.
vibs: what is WACC?
ribkanemo: weighted average cost of capital (WACC)
aras: WACC says everything about the capital structure of a project or a company. It is the average debt + equity used by a company. It is mostly used as a discount rate when undertaking a DCF analysis to calculate the NPV.
StanleyMo: nice explain aras,
studyprep: also note that it is 'weighted' average. because cost of borrowing and cost of selling equity are different for the same company.
TiredHand: To explain WACC, if for example you were working with a project that was 70% debt funded and 30% equity funded, and the debt interest rate (post tax) is 8% and the cost of the equity is 5% then the WACC = (0.7 x 8%) + (0.3 x 5%) = hold on that doesn't work. Ignore me
meeruka: can somebody explian reinvestment problem.iam unclear with description
sunnyhui: reinvestment problem - irr assume the same interest rate for investment it same for all cashflow and at same time, but if cashflow is at different times then interest rate is different hmm IRR can be inaccurate estimate at times
chesschh: we still have to learn how to calculate npv and irr
dweik: WACC takes the weighted average cost of the capital used to fund the project.

Let's say a company uses 50% debt and 50% equity.

The debt costs 5% and the equity costs 6%.

The WACC will be (5 * 0.5) + (6 * 0.5) which will give a WACC of 5.5%

Calculating the components of the WACC is a different story all together though.
012905nv: Thank you for the comments on WACC, it is very helpful!!
khalifa92: ignore this reading because ull go through this all in corporate finance with a better understanding and more exhaustive information (use textbook).