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.