NPVvs IRR1
NPVvs IRR1
NPVvs IRR1
For investments with “traditional” cash flows, it doesn’t make a difference whether we consider
NPV or IRR in order to make the investment decision with regard to a single project. Both will
lead to the same decision. Consider the following cash flows:
Of course, the decision whether or not to invest in this project will depend on the discount rate.
With traditional cash flows – a negative cash flow to start the project, and positive cash flows
thereafter – it will always be the case that higher discount rates correspond to lower values. In
fact, you can easily graph this relationship in what is referred to as an NPV Profile:
NPV Profile
$25,000.00
$20,000.00
$15,000.00
$10,000.00
$5,000.00
$0.00
5%
0%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
($5,000.00)
($10,000.00)
The y-axis in this graph is the NPV, while the x-axis shows increasing discount rates. The shaded
area in this graph represents the profitable projects. If the discount rate of this project goes
above 47.59%, the project is not profitable; for any discount rate below that, it is. This is
observable on the graph as this is the point where the NPV profile crosses the x-axis.
Note that the decision rule for either NPV or IRR yields the same decision under any discount
rate for this project. The NPV rule dictates accepting the project when the NPV is positive – the
shaded area in this graph. The IRR rule matches this exactly, as it would imply acceptance as
long as the discount rate is below the IRR. Since the IRR is where the NPV profile crosses the x-
axis, this maps perfectly to the NPV decision.
This is only true because of the shape of this NPV profile. As long as the NPV is positive at a rate
of zero (i.e., the nominal cash flows add to a number greater than zero), and the cash flows are
traditional, this will be true. However, there are other possibilities:
NPV Profile
$5,000.00
$4,000.00
$3,000.00
$2,000.00
$1,000.00
$0.00
55%
90%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
60%
65%
70%
75%
80%
85%
95%
100%
($1,000.00)
($2,000.00)
($3,000.00)
($4,000.00)
In this case, there are multiple IRRs. This is always a possibility if there are multiple sign changes
in the cash flows. In this case, the NPV profile crosses the x-axis twice; once at 5%, and again at
82%. The NPV rule still applies; if the discount rate yields a positive NPV, you should accept the
project. That corresponds to the shaded area again. Note that this does not map to the IRR rule,
which now might lead to the wrong decision; the project should be accepted for any discount
rate between the two IRRs. This will not always apply to a project with multiple IRRs, sadly, and
the only way to really be sure is to map the NPV profile as we have done here. Alternatively, the
best approach is to simply use the NPV measure in cases with multiple sign changes in the cash
flows.
The IRR for project A is about 48%, as discussed earlier. Project B’s IRR is 55%. Choosing
between these two projects based on IRR, you would select project B. However, using NPV
might lead you to a different decision, depending on what the discount rate is:
NPV Profiles
$25,000.00
$20,000.00
$15,000.00
$10,000.00
$5,000.00
$0.00
0% 20% 40% 60% 80% 100% 120%
($5,000.00)
($10,000.00)
In cases where the discount rate is below 30%, project A is more profitable. At higher discount
rates, C is more profitable. You cannot simply judge the projects based on their relative IRR.
You can find this crossover rate, if it exists, by calculating the IRR of the incremental cash flows
(i.e., subtract all of project A’s cash flows from project C’s, use that as your cash flows and
calculate the IRR).