Comparison Between Net Present Value and Internal Rate of Return

Decisions in capital investment will have major impact on the future well-being of the firm. Normally NPV and IRR 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. This study objective is to analyze conflicting areas between NPV and IRR.

In analyzing conflicting areas between NPV and IRR, this paper has been divided into seven parts. In the first part Introduction, Second part objectives, Third part Review of literature, Fourth part theoretical aspects of NPV and IRR, Fifth part types of investment decisions, in the sixth part Comparison between NPV and IRR and in the last part conclusion. The conclusion is both NPV and IRR methods are equivalent as regards the acceptance or rejection of independent conventional investments. Investment projects in the case of lending, Higher rate earned project is preferable, Whereas in the case of borrowing Lower rate paid project is preferred. The IRR rule may also lead multiple rates of return for non-conventional project and fails to work under varying cost of capital conditions. Under a number of situations (at timing of cash flows, scale of investment, or project life span), the IRR rule can give a misleading signal for mutually exclusive projects. Since the IRR violates the value additively principle; since it may fail to maximise wealth under certain conditions; and since it is cumbersome, the use of the NPV rule is recommended. In case of mutually exclusive projects having unequal lives, project can be selected on the basis of Annualized NPV and the project which is having higher Annualized NPV(based on Cash Inflows) or lower Annualized NPV(based on Cash Outflows) should be selected. Even though All do not accept, Advocates of reinvestment assumption calculates terminal values of the project to prove their point through Modified Internal Rate of Return. There is no problem in using the NPV method when the opportunity cost of capital varies over time. Cash flows should be adjusted to accommodate the inflation factor so that the capital budgeting decisions reflect the true picture.