I would like all of you to think about the difference b
etween IRR and NPV. There is a significant but somewhat
subtle difference between these two techniques although
they may seem at first to yield the same answer to a
capital budgeting/investment decision.
For example why might I pick a project/investment that
has a smaller NPV than another project? Or why might I
chose to invest in a project that has a lower IRR than a
competing project??
hint: the answer has to do with size, risk and duration
Take a look at the attached file I have prepared.It shows two different projects that have
the same initial investment and the same IRR –but have different cash flows over a
different period of time.
Note that in both cases the IRR is the same 29%-one
project has a long incoming cash flow and the other only
a short one year cash flow but the IRR is the same. Yet
when you do NPV at a low interest rate 10% for example
one project comes out the winner, however if you change
the interest rate to 50% the projects are reversed and
the other project appears to be better????
What conclusions do you come to from this?? Which
project would you pick to invest in??
You only have $400 and must chose one or the
other.
Remember that YOU have no cost of capital this is your only savings and you must choose one or the other project. The calcualtions I have shown you at 10% and 50% are irrelevant-both these projects have a 29%IRR
Attachments: irrnpvgraph1.xls; npvirrcomp1.xls;
I have numerous engineering textbooks that address capital budgeting and investment from my previous studies. The synopsis of their address of the topic is as follows: when independent projects (not an either or situation) are being evaluated, IRR and NPV always lead to the same accept or reject decision. For two mutually exclusive projects (can accept one or the other or neither but not both), the IRR and NPV may lead to the same or opposing decisions. The difference between IRR and NPV is that IRR assumes that the firm can reinvest at the project's IRR while NPV assumes that the rate at which cash flows can be reinvested is the cost of capital. There are two basic reasons why conflicts occur between decisions to use NPV and IRR: 1. size (or scale) differences in the two projects and/or 2. timing of each project's cash flows are significantly different, with one of the projects cash flows coming early in the project's life (such as in our example of Project B) compared to the cash flows of the other project, which come over a longer period of time (Project A). As seen on the graph, Project A has a much steeper NPV profile slope than Project B. This reflects that Project A is very sensitive to increases in the cost of capital, which also indicates increased risk. This is as a result of the timing and size of cash flows. Project A's cash flows are smaller and spread over a long period of time whereas Project B's cash flows are large and come earlier. This exposes it to less change in cost of capital (less risk) and is depicted by a much more gradual sloped line than Project A. These circumstances allude to why I might select a project that has a smaller IRR: for projects with big late costs, the better projects will have lower internal rates of return, the opposite of the rule for normal projects that have their costs early and their positive returns later.
In this instance, I would choose to invest my $400 in Project B due to its relatively short-timed, large cash flows (less risk from exposure to increases in cost of capital) and based on NPV, which assumes that the money could be reinvested at the cost of capital and is always a better method to use when projects are mutually exclusive. In this instance, I would choose to invest my $400 in Project B due to its relatively short-timed, large cash flows (less risk from exposure to increases in cost of capital) and based on NPV, which assumes that the money could be reinvested at the cost of capital and is always a better method to use when projects are mutually exclusive.
Primarily, it implicitly assumes that interim cash flows from the investment (if any) can and will be reinvested at the pre-defined IRR rate, whereas NPV only assumes that interim cash flows will be reinvested at a rate needed to recover the firm's cost of capital. Arcane this may sound, but IRR ends up making investment projects look attractive on the false premise that there is an endless supply of equally attractive interim projects. How serious can this flaw be?
According to McKinsey, they recently reviewed 23 major capital projects approved over five years at a large industrial company with an average IRR of 77%. With the return on capital adjusted to the company's average rate, the average return fell to 16%. More important for financial decision-makers, the most-highly rated project by IRR fell to 10th place on the revised analysis."
from:
http://www.bmacewen.com/blog/archives/2004/09/irr_vs_npv_and.html
Based on the information and charts provided, I would invest my $400.00 with Project B because it has large cash flow for a short-time and it is based on NPV. The NPV approach means that I will be able to reinvest my money at a rate that I need to recover the initial cost of capital. The IRR approach means that I will have to reinvest my money at a pre-determined rate, which will take longer for me to recover the initial investment.
Also see textbook p540-543
It's a great answer to the question as to which method is better. It is dependent upon the company's goals and what factors are important to them in distinguishing btwn. investment alternatives.
I think that the first thing to consider is that NPV and IRR are tools that allow you to determin an investment that matches the companies goals. First I think that it would depend on the size of the investment. Granted everyone wants the biggest bang for the buck but lets say a company has $10,000 to invest. If there were two investments to choose from and one requires an investment of $3000 and has an IRR of 10% but another investment requires $10,000 investmenet with an IRR of 8%. Granted the first investment would be the better choice you have to also consider that if there was no other investment opportunity for the remaining $7,000 then investment two becomes a better choice when you take into account the cost of not having that money working for you.
Along with the size of the investment there is also the risk. If I use the same scenario above I stated that option two may be a better choice. This would change if the second choice was a long term investment and then the risk of having the money tied up in a lower returning investment increases. Not only is there the risk that a better investment may come along, but there is always the inferent inflation and interest rate risks of a long term investment.
As far as the investment goes in this situation I would also choose the short term investment. This would be based on the fact that if I was investing my last $400 in savings I would be highly suseptible to risk. This is why although there is a much greater opportunity to make more money with the long term investment there is too much risk for a down side that I would not be able to tolerate in this scenario.
From a capital budgeting website, http://www.investopedia.com/ask/answers/05/irrvsnpvcapitalbudgeting.asp
“All other things being equal, using internal rate of return (IRR) and net present value (NPV) 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. IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment.
Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. Recall that IRR is the discount rate that makes a project break even. If market conditions change over the years, this project can have two or more IRRs.
Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it is considered to be financially worthwhile.”
The IRR is the actual rate of return “expected” given future cash flows from an investment.
Using just IRR has two main disadvantages (from pg 543 of our text):
1. It assumes that one can reinvest a project’s intermediate cash flows at the IRR, which is rarely true, and
2. It can create ambiguous results since it does not take into account the size of the project. For example, you might invest $400 and make $40 over a year to get an IRR of 10%, but it you invest $4000 and make $300 after a year, you get an IRR of only 7.5%. Based solely on IRR, you would pick the higher return of 10% to make $40 and forego making $300 over the same period so your total accumulated wealth is less.
At http://searchcrm.techtarget.com/... it states:
“IRR is not a great indicator as to the magnitude of investment needed, benefit value or payback, so the returns may be high, but the investment benefits [may not be] significant and/or payback (risk) too high.”
The book states that using the NPV “is a superior alternative to the IRR criterion and requires only one additional piece of information-the organization’s cost of capital-for its calculation.” But for our problem, we have no cost of capital.
Again, from http://searchcrm.techtarget.com/... it states:
“NPV is a formula that tallies all of the net benefits of a project (benefits – costs), adjusting all results into today's dollar terms. This is different than just tallying up all of the net benefits of a project over a three year period without discounting as the cumulative benefits without discounting overstate the overall project value, especially when the project has many of the investment costs up-front or in year one, and the benefits are not really kicking in until later years (where the time-value of money discounting reduces the overall value of these benefits). NPV is great at tallying up the net benefits over an investment horizon so that different projects can be compared as to the value they return to the company, but this metric alone does not highlight how long it may take to achieve the benefits (as payback period does). Nor does it highlight the ratio of the costs versus the net benefits.”
What conclusions do I come to from this? Which project would I pick to invest in?
Given the $400 is an investment and because I am not a risk taker, I would take the short-term project B and get my return as soon as possible and then reinvest it in something better after the year. There are a few reasons for my decision:
1. The investment pays off sooner so my money is committed for a much shorter term.
2. The effects from inflation are far less than the long-term investment (project A).
3. The effects on a change in cost of capital are far less (i.e., I don’t make as much with a low cost of capital but I don’t lose as much with a high cost of capital).
The short-term investment (project A) has less variation in NPV given a varying cost of capital because it does not have the benefit of time for the interest to take affect whereas the long-term investment is very sensitive to changing interest rates.
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An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting critierion should be accepted.
Mutually Exclusive Projects are a set of projects from which at most one will be accepted. For example, a set of projects which are to accomplish the same task. Thus, when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted.
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