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Why NPV Is Better Than Irr (40 Points)

The professor gave an example to explain why NPV is better than IRR for capital budgeting decisions. In the example, Project Large had a lower IRR than Project Small but a much higher NPV. While the IRR would suggest choosing Project Small, Project Large was clearly more profitable given the firm's cost of capital. Ed used this example to convince his company to switch from using IRR to NPV for decisions. The company agreed NPV was a better measure as it shows how much value each project will add to the firm.

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1K views2 pages

Why NPV Is Better Than Irr (40 Points)

The professor gave an example to explain why NPV is better than IRR for capital budgeting decisions. In the example, Project Large had a lower IRR than Project Small but a much higher NPV. While the IRR would suggest choosing Project Small, Project Large was clearly more profitable given the firm's cost of capital. Ed used this example to convince his company to switch from using IRR to NPV for decisions. The company agreed NPV was a better measure as it shows how much value each project will add to the firm.

Uploaded by

Dong Rosello
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Salazar, Precious Grace A.

BSA2.2
WHY NPV IS BETTER THAN IRR (40 points)
Read and analyze the given scenario and answer the given questions.

Buffett University recently hosted a seminar on business methods for managers. A finance
professor covered capital budgeting, explaining how to calculate the NPV and stating that it
should be used to screen potential projects. In the Q&A session, Ed Wilson, the treasurer of an
electronics firm, said that his firm used the IRR primarily because the CFO and the directors
understood the selection of projects based on their rates of return but didn’t understand the
NPV. Ed had tried to explain why the NPV was better, but he simply confused everyone, so the
company stuck with the IRR. Now a meeting on the firm’s capital budget is approaching, and
Ed asked the professor for a simple way to explain why the NPV is better.
The professor recommended the following extreme example. A firm with adequate access to
capital and a 10% WACC is choosing between two (2) equally risky, mutually exclusive
projects. Project Large calls for investing $100,000 and then receiving $50,000 per year for 10
years, while Project Small calls for investing $1 and receiving $0.60 per year for 10 years.
Each project’s NPV and IRR are shown in the table:

Project Large (L) Project Small (S)

𝐶0 = −$100,000 𝐶0 = −$1.00
𝐶1−10 = $50,000 𝐶1−10 = $0.60
𝐼/𝑌 = 10 𝐼/𝑌 = 10

𝐼 = 59.4%
𝑁𝑃 = $207,228.36
𝑁𝑃 = $2.69
𝐼 = 49.1%

The IRR says choose S, but the NPV says take L. Intuitively, it’s evident that the firm would
be better off choosing the large project despite its lower IRR. With a cost of capital of only
10%, a 49% rate of return on a $100,000 investment is more profitable than a 59% return on a
$1 investment.
When Ed gave this example in his firm’s executive meeting on the capital budget, the CFO
argued that this example was extreme and unrealistic and that no one would choose S despite
its higher IRR. Ed agreed, but he asked the CFO where the line should be drawn between
realistic and unrealistic examples. When Ed received no answer, he went on to say that (1) it’s
hard to draw this line and (2) the NPV is always better because it tells us how much value each
project will add to the firm, and value is what the firm should maximize. The president was
listening, and he declared Ed, the winner. The company switched from using IRR to NPV, and
Ed is now the CFO.
QUESTIONS:
• Do you agree that the company should switch from IRR to NPV?
Both methodologies, such as NPV and IRR, are commonly employed in project
evaluation. However, deciding which method is preferable necessitates balancing the
advantages and disadvantages of each evaluation approach. IRR calculates a project's total
rate of return over a period of time. The fundamental goal of IRR is to find a rate that
allows the project's cashflows to break even. This strategy, however, is thought to be
ineffective for investors because it relies on a narrow pool of data. Also, IRR should only
be used for uncomplicated projects with a single funding source and no extra
complications. Most significantly, IRR is based on the incorrect assumption that cash flows
are reinvested in the project's IRR. NPV, on the other hand, is expressed as a dollar figure.
It offers information on the amount of money generated by the project over time. The
purpose of this method is to determine if the project's net inflows will exceed the cost of
investment in year 0. In the context of making a decision. Because the calculation
encompasses numerous aspects, NPV is thought to be superior and more beneficial to
investors. It is also preferable in terms of project complexity. It also assumes that the
project's cash flows are reinvested at the firm's cost of capital, which is correct. After
analyzing the advantages and disadvantages of each strategy, it is reasonable to conclude
that switching to NPV is a wise move.

• Why is NPV better than IRR in this scenario?


In this case, NPV is preferable to IRR because, while having a lower IRR than
project S, project L generates a considerable amount of surpluses, significantly above the
2.69 generated by project S. NPV can also be modified in a variety of ways. By dividing
the NPV by the PV factor, we can compare the yearly cash inflows of each project. From
year one to year ten, project L creates a yearly NPV of 33, 725, whereas project S creates a
yearly NPV of.4378. If you choose project S because IRR urged you to, the company will
miss out on the possibility to bring in more money if project L is chosen. Therefore, it is
only proper to use NPV or IRR in this scenario.

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