Tuesday, February 9, 2010


Net Present Value versus Internal Rate of Return

The net present value (NPV) and the internal rate of return (IRR) methods are two closely related investment criteria. Both are time adjusted methods of measuring investment worth. In case of independent projects, two methods lead to same decisions. However, under certain situations, a conflict arises between them. It is under these cases that a choice between the two criteria has to be made.

Evaluation of NPV and IRR

It is important to distinguish between conventional and non-conventional investments in discussing the comparison between NPV and IRR methods. A conventional investment can be defined as one whose cash flows take the pattern of an initial cash outlay followed by cash inflows. Conventional projects have only one change in the sign of cash flows.

In the case of conventional investments, which are economically independent of each other, NPV and IRR methods result in same accept or reject decision if the firm is not constructed for funds in accepting all profitable projects. Same projects would be indicated profitable by both methods. The logic is simple to understand. All projects with positive NPV’s would be accepted if the NPV method is used, or projects with IRR higher than the required rate of return would be accepted if the IRR method were followed. The last or marginal project acceptable under the NPV method is the one, which has zero NPV; while using the IRR method, this project will have an IRR equal to the required rate of return. Projects with positive NPV would also have IRR higher than the required rate of return and the marginal project will have zero present value only when its IRR is equal to the required rate of return.

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