Lecture: Internal Rate of Return (IRR) and Net Present Value (NPV)
Key Concepts
Internal Rate of Return (IRR)
IRR is a percentage that measures the rate of return on investment.
Popular due to its intuitive measure of return but has notable limitations.
Issues with IRR:
Does not account for project scale.
Can be misleading for mutually exclusive projects.
Net Present Value (NPV)
NPV accounts for the absolute amount of economic profit.
Considers both the return rate and the scale of investment.
Preferred method: Always refer to NPV to confirm decisions based on IRR.
Problems with IRR
Scale Problem
Occurs with mutually exclusive projects.
Example: Comparing $1 investment with $2 return vs. $1000 with $1500 return.
IRR of smaller project may be higher, but NPV shows larger project is economically preferable.
Resolution: Prioritize NPV over IRR when projects differ in scale.
Timing Problem
Concerns projects with different cash flow distributions over time.
Example: Project A pays more initially, Project B pays more later.
IRR may not accurately reflect the better project choice without considering timing.
Resolution: Use NPV to account for timing issues.
Alternatives and Comparisons
Profitability Index (PI)
Ratio of present value of future cash flows to initial investment.
Represents a scaled version of NPV.
Limitations: Same scale issues as IRR.
Other Methods
Payback Period: Simple, but not preferred; lacks depth and comprehensiveness.
Discounted Payback Period: Infrequently used.
Summary
Most Reliable Method: NPV.
Why IRR is Popular: Intuitive and provides a clear rate of return.
Practical Advice: Always validate IRR with NPV; NPV is universal and does not fail in decision-making.
Ranking of Methods:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Payback Period
Discounted Payback Period
Recommendation for Decision Making: Use NPV alongside IRR to ensure robust and accurate financial decisions, particularly in mutually exclusive projects and varied cash flow situations.