Actuarial Science: NPV vs IRR, A Comparison
Planning to make an investment decision? Confused on how to know its profitability? Well, there are two most common approaches used and they are Net Present Value (NPV) and Internal Rate of Return (IRR). Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
- Positive NPV or NPV>0 implies that the value of revenues (cash inflows)is greater than the costs(cash outflows)
- Negative NPV or NPV<0, implies vice versa.
ADVANTAGES OF NPV
- It accepts conventional cash flow pattern.
- It takes into consideration both before & after cash flow over the life span of a project.
- It considers all discount rates that may exist at different points of time while discounting back our cash flows.
- Discount rates are used in calculating NPV; the risk of undertaking the project (Business Risk, Financial Risk, and Operating Risk) gets factored into this method.
DISADVANTAGES OF NPV
- It might not give you accurate decision when the two or more projects are of unequal life.
- It does not give
the clarityon how long a project or an investment plan will generate positive NPV due to its simple calculation.
- NPV method suggests accepting an investment plan which provides positive NPV but it doesn’t provide an accurate answer to at what period of time you will achieve positive NPV.
- Calculating the appropriate discount rate for cash flows is difficult.
IRR: also referred as “yield to redemption” or “yield per annum”. The internal rate of return for an investment project is the effective rate of interest that equates the present value of inflows and outflows. Higher IRR represents a more profitable project. It is a commonly used concept in project and investment analysis, including capital budgeting. The IRR of a projector or investment is the discount rate that results in an NPV of Zero.
- However, IRR need not be positive. Zero return implies investor receives no return on investment. If the project has only cash inflows then the IRR is infinity.
- When IRR > cost of capital, NPV will be positive
- When IRR < cost of capital, NPV will be negative.
ADVANTAGES OF IRR
- This approach is mostly used by financial managers because the ranking of project proposals is very easy under the internal rate of return since it indicates percentage return.
- IRR method gives you the advantage of knowing the actual returns of the money which you invested today.
- It is very simple to interpret an investment decision or a project after the IRR is calculated. If IRR exceeds the cost of capital, then accept the project otherwise not.
DISADVANTAGES OF IRR
- IRR tells you to accept the project or investment plan where it is greater than the weighted average cost of capital but in case, if the discount rate changes every year then it is difficult to make such comparison.
- If there are two or more mutually exclusive projects (where acceptance of one project rejects the other from concern) then in that case too, IRR is not effective.
- It ignores the actual monetary value of benefits. One should always prefer a project value of $1000000 with 18% rate of return over a project value of $10000 with a 50% rate of return. But in the IRR method, the latter project with less monetary benefit will be given preference, simply because the IRR of 50% is higher than 18%.
XYZ Company is planning to invest in a plant; it generates the following cash flows.
From the above information calculate NPV & IRR. The discounting rate is 10%. Suggest whether XYZ ltd should invest in this plant or not.
NPV = CF/ (1+r) ^t-Cash outflow.
Where, CF= Cash inflow, r=discount rate, t= time, Cash outflow= Total Project Cost.
IRR: CF/ (1+IRR) ^t=Cash Outflow.
Now on comparing the IRR with the discount rate, From the above calculation you can see that the NPV generated by the plant is positive and IRR is 14% which is more than the required rate of return.
This implies, when the discounting rate is 14% NPV will become zero. Here 14% is the investor’s required rate of return. Had the discount rate been higher than the IRR, say the discount rate offered to the company is 16% then the NPV will be a negative amount. A positive NPV makes the investment proposal a viable option.
So, XYZ Company should invest in the plant.
So, if you are evaluating two or more mutually exclusive projects it’s advisable to go for NPV approach instead of IRR approach. For selecting the best investment plan, NPV method is preferred due to its realistic assumptions and better measure of profitability. IRR method is a great compliment to NPV and will provide you accurate analysis for investment decisions.
So why is IRR still commonly used in Capital budgeting? It’s because of its reporting simplicity. The NPV method is considered complex and require assumptions at each stage.
Regardless of its disadvantages, NPV is widely used as it is a better measure of profitability than the IRR.
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