Internal Rate of Return: Capital Budgeting Decision Method

Is Internal Rate of Return or Net Present Value Better?

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Financial managers and business owners usually like performance measures expressed in percentages instead of dollars. As a result, they tend to like capital budgeting decisions expressed as a percentage, like internal rate of return (IRR) instead of in a dollar amount, like net present value (NPV).

However, there is a problem with this; even though the internal rate of return is usually a reliable method of determining whether or not a capital investment project is a good investment for a business firm, there are conditions under which it is not reliable, but the net present value is.

What Is Internal Rate of Return?

What is an internal rate of return? Simply put, it is a way of expressing the value of a project in a percentage instead of in a dollar amount.

In the language of finance, the internal rate of return is the discount rate or the firm's cost of capital, that forces the present value of the cash inflows of the project to equal the initial investment. This is like a break-even analysis, and it's equivalent to forcing the net present value of the project to equal $0. Put differently, the internal rate of return is an estimate of the rate of return on the project.

The internal rate of return is a more difficult metric to calculate than net present value. With an Excel spreadsheet, it is a simple function to iterate the information and find the rate of return that sets the project value to $0. In the past, financial managers had to calculate it using trial and error which was a long and complex calculation. 

The IRR method is usually correct, but there are some exceptions that will make it wrong.

Decision Rules

If the IRR of a project is greater than or equal to the project's cost of capital, accept the project. However, if the IRR is less than the project's cost of capital, reject the project. The rationale is that you never want to take on a project for your company that returns less money than you pay to borrow money (cost of capital).

Just like for net present value, you have to consider whether you are looking at an independent or mutually exclusive project. For independent projects, if the IRR is greater than the cost of capital, then you accept as many projects as your budget allows. For mutually exclusive projects, if the IRR is greater than the cost of capital, you accept the project. If it is less than the cost of capital, then you reject the project.

Net Present Value: Better in Some Cases

The more commonly-used NPV is found using a discounted cash flow model, and the net present value calculation discounts each cash flow separately, which makes it a more refined analysis than an IRR calculation. If rates of return vary over the life of the project, an NPV analysis can accommodate these changes. The NPV model also works better when the discount rate isn't known, and as long as a project's NPV is greater than zero, the project is considered financially viable.

Present value means that a project's future cash flows are discounted to their present value using a discount rate. You essentially calculate the difference between the cost of a project, or its cash outflows, and the income generated by that project, or the cash inflows.

At times, the decision criteria of internal rate of return and net present value give different answers in a capital budgeting analysis. Here lies one of the problems with internal rate of return in capital budgeting. If a firm is analyzing mutually exclusive projects, IRR and NPV may give conflicting decisions. This can happen if any of the cash flows from a project are negative, aside from the initial investment.

Summary

Everything points to the net present value decision method being superior to the internal rate of return decision method. One last issue that business owners have to consider is the reinvestment rate assumption. IRR is sometimes wrong because it assumes cash flows from the project are reinvested at the project's IRR. However, net present value assumes cash flows from the project are reinvested at the firm's cost of capital which is correct.