Understanding IRR and NPV in Investments (Part 3)

Oct 1, 2024

Lecture on Internal Rate of Return (IRR) and Related Issues

Introduction to IRR Scale Problem

  • Mutually Exclusive Projects: Projects that cannot be undertaken simultaneously.
  • Scale Problem: An issue when choosing between mutually exclusive projects based on IRR.
    • Example: Investment options with different scales may mislead decision-making if only IRR is considered.
    • Option 1: $1 investment, return $2 (100% IRR).
    • Option 2: $1000 investment, return $1500 (50% IRR).
    • Correct choice based on Net Present Value (NPV) should be Option 2.

Comparison of IRR and NPV

  • IRR: Measures percentage rate of return without considering project scale.
  • NPV: Considers absolute amount of economic profit, making it more reliable.
  • Conflict: NPV vs IRR in mutually exclusive projects.

Examples of Scale Problem

  • Small vs Large Projects:
    • Small Project: $1000 investment, $2000 return.
    • Large Project: $2000 investment, $3500 return.
    • NPV analysis reveals larger project is more profitable despite lower IRR.

Timing Problem (Crossover Problem)

  • Issue: Different cash flow distributions over time can lead to misleading IRR comparisons.
  • Graphical Analysis: NPV profiles intersect, showing preference changes depending on discount rates.
    • Example: Different cash flow timing between projects affects preference.
  • Crossover Rate: The discount rate at which NPV profiles intersect, indicating preference shifts.

Profitability Index (PI)

  • Definition: Ratio of present value of future cash flows to initial investment.
  • Usage: Similar to NPV but in ratio form, indicating how much present value exceeds initial investment.
  • Advantages: Intuitive and useful with limited funds.
  • Limitations: Similar issues as IRR with scale problems.

Summary

  • Preferred Method: Net Present Value (NPV) is the most reliable and universally preferred method.
    • Handles scale, timing, and existence issues better than IRR and PI.
  • Other Methods: IRR is popular due to its intuitive appeal but should always be checked against NPV.
    • Profitability Index is a useful complement but not as widely used.
    • Payback Period and Discounted Payback Period are less reliable and more supplementary.

Conclusion

  • When in doubt, always confirm with Net Present Value to ensure accurate decision-making.