NPV vs IRR

Both the techniques are most popular discounted cash flow techniques used in capital budgeting but sometimes there could be situation where an analyst needs to choose between any of the two. When you are analyzing a single conventional project, then both the tool will give you the same decisions. Once there are mutually exclusive projects*, then dilemma can be faced by analysts while choosing the projects.

Superiority of NPV (Net  Present Value) over IRR (Internal Rate of Return)

1) NPV is preferred in case of mutually exclusive projects. Conflict arises between the two is because of two major factors i.e. first, different timing of cash flows and second is the size of projects. 

2) IRR may give dubious results such as multiple or no IRR in few cases where cash flows are changing signs i.e positive / negative (e.g. case of reclamation in mining projects). Hence NPV is preferred over IRR in that case. 

Major problems which are being faced while using IRR are

a) Multiple IRR: Projects with varied cash inflows and outflows can give you two IRRs where making decisions become very difficult. 

b) No IRR: In certain cases, IRR technique may give some indeterminate results. Consider a proposal with annual cash flow of {-$1000, +$5000 & -$6000}

The IRR for these cash flows satisfies below mentioned equation

This means that there are two values of IRR that satisfies the equation i.e. IRR = 1 = 100% & IRR = 2 = 200% and hence leads to indeterminate result.

3) The reinvestment assumption of NPV is more economically realistic. It states that cash flows will be reinvested near or at the project’s current cost of capital while IRR assumes that cash flows can be reinvested at the projects IRR. 

4) NPV of different projects are additive while the IRRs can’t be added.

Superiority of IRR over NPV

1) IRR is sometimes preferred over NPV because IRR gives percentage return while the NPV gives absolute return.

*Mutually exclusive projects: If there are two projects i.e. A & B, you can either choose A or B. You can’t choose both.