© 2000 John Petroff
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© 2000 John Petroff |
4)- Comparison between NPV and IRR
The two methods, NPV and IRR, are identical, with the exception of a few special cases discussed in most corporate finance textbooks and outlined in Chapter 10 Section E-5. In addition, in the Appendix to this chapter, where cases in which multiple outlays cause IRR calculation to yield more than one solution are presented. Otherwise, essentially, in both theory and practice, the two methods are used interchangeably. But there are occasions for one method to be more useful than the other. This is especially true when not just one but several projects are considered, and they are looked upon as mutually exclusive. For instance, that is the case when some project(s) cannot be accepted because of a capital constraint (i.e. maximum sum of all outlays in a given time period). The rule is to choose the combination of projects that yields the largest total NPV. Here, starting by accepting the project with the largest NPV is not always the right first step because it depends on the size of outlays for each respective project, and a combination of projects with smaller outlays may sum to greater combined NPV. In such as case, accepting the project with the highest IRR assures that the project with the largest contribution is chosen irrespective of size. Then choosing subsequent projects with IRR in descending order seems to lead to the optimal solution. But it is not necessarily so, if for instance, the last project chosen prevents accepting a lower IRR project that generates nevertheless a larger total NPV because of its bigger size. It is indeed the total increase in value that the decision must maximize. Thus, seeking optimum total NPV may require using both methods.
A more scientific approach is to look at capital constraint as a constraint optimization problem which best solved with linear programming briefly introduced in Chapter 5 Section G and illustrated in Chapter 10 Section E-7.
Another difficulty appears to exist when projects have different lives (i.e. one project generates benefits over a longer period of time than another project). Here also, IRR does not have superiority over NPV because the easiest method is to calculate an annualized NPV. Another method recommended in some manual is to consider cash flow reinvestment opportunities and calculate an annuity equivalent NPV or an infinite life equivalent NPV, which will be discussed in Chapter 10 Section 10E-3.
NPV is recognized in financial circles as the measure that must be maximized. It is the most common method. IRR is appealing because it is a relative measure, and it is easily compared (just as yield on bonds and P/E for stocks). IRR suffers from difficulty of calculation, even with availability of specialized calculators and computer programs. In addition, using only IRR does not guarantee that wealth will be maximized as illustrated above in the case of capital constraint. Yet, NPV is not an infallible method either in special cases. Thus, older methods that were used before discounted cash flow methods, can come in handy and are still occasionally found more appropriate. In addition, there are circumstances where discounting cash flows is not feasible. This is explored in the following sections.
See review questions Q-3G4.1 through Q-3G4.3.
See research assignment R-4.19.
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