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Financial Management - Capital Budgeting – A Conceptual Framework

Comparison Between NPV and IRR (NPV VS. IRR) - Evaluation Of Capital Projects

   Posted On :  19.06.2018 11:39 pm

The Net Present value method and the Internal Rate of Return Method are similar in the sense that both are modern techniques of capital budgeting and both take into account the time value of money.

Comparison Between NPV and IRR (NPV VS. IRR)
 
The Net Present value method and the Internal Rate of Return Method are similar in the sense that both are modern techniques of capital budgeting and both take into account the time value of money. In fact, both these methods are discounted cash flow techniques. However, there are certain basic differences between these two methods of capital budgeting:

1. In the net present value method the present value is determined by discounting the future cash flows of a project at a predetermined or specified rate called the cut off rate based on cost of capital. But under the internal rate of return method, the cash flows are discounted at a suitable rate by hit and trial method which equates the present value so calculated to the amount of the investment. Under IRR method, discount rate is not predetermined.

2. The NPV method recognizes the importance of market rate of interest or cost of capital. It arrives at the amount to be invested in a given project so that its anticipated earnings would recover the amount invested in the project at market rate. Contrary to this, the IRR method does not consider the market rate of interest and seeks to determine the maximum rate of interest at which funds invested in any project could be repaid with the earnings generated by the project.

3. The basic presumption of NPV method is that intermediate cash inflows are reinvested at the cut off rate, whereas, in the case of IRR method, intermediate cash flows are presumed to be reinvested at the internal rate of return.’

4. The results shown by NPV method are similar to that of IRR method under certain situations, whereas, the two give contradictory results under some other circumstances. However, it must be remembered that NPV method using a predetermined cut-off rate is more reliable than the IRR method for ranking two or more capital investment proposals.

(a) Similarities of Results under NPV and IRR


Both NPV and IRR methods would show similar results in terms of accept or reject decisions in the following cases:

1. Independent investment proposals which do not compete with one another and which may be either accepted or-rejected on the basis of a minimum required rate of return.

2. Conventional investment proposals which involve cash outflows or outlays in the initial period followed by a series of cash inflows.

The reason for similarity of results in the above cases lies on the basis of decision-making in the two methods. Under NPV method, a proposal is accepted if its net present value is positive, whereas, under IRR method it is accepted if the internal rate of return is higher than the cut off rate. The projects which have positive net present value, obviously, also have an internal rate of return higher than the required rate of return.

(b) Conflict between NPV and IRR Results


In case of mutually exclusive investment proposals, which compete with one another in such a manner that acceptance of one automatically excludes the acceptance of the other, the NPV method and IRR method may give contradictory results. The net present value may suggest acceptance of one proposal whereas, the internal rate of return may favour another proposal. Such conflict in rankings may be caused by any one or more of the following problems:

1. Significant difference in the size (amount) of cash outlays of various proposals under consideration.

2. Problem of difference in the cash flow patterns or timings of the various proposals and

3. Difference in service life or unequal expected lives of the projects.
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