For single and independent projects with conventional cash flows, there is no conflict between NPV and IRR decision rules. However, for mutually exclusive projects the two criteria may give conflicting results. The reason for conflict is due to differences in cash flow patterns and differences in project scale.
Example (Ranking conflict due to differing cash flow patterns)
The cash flow associated with Project X and Project Y is shown below:
Year | 0 | 1 | 2 | 3 | 4 |
Project X | -400 | 160 | 160 | 160 | 160 |
Project Y | -400 | 0 | 0 | 0 | 800 |
Solution:
Let us first calculate the NPV and IRR for the two projects.
NPV (in $ millions) | IRR (in %) | |
Project X | 107.17 | 21.86 |
Project Y | 146.4 | 18.92 |
Reasons for going with NPV instead of IRR:
Besides differences in cash flow patterns, there can be ranking conflicts due to differences in project size as well. Consider two projects one with an initial outlay of $1 million and another project with an initial outlay of $1 billion. It is possible that the smaller project has a higher IRR, but the increase in firm value (NPV) is small as compared to the increase in firm value (NPV) of the larger project.
If a project has unconventional cash flows, it can have multiple IRRs, i.e., there are more than one discount rates that will produce an NPV equal to zero. The NPV profile of a project with multiple IRRs intersects the x-axis at more than one point.
Some projects do not have an IRR, i.e. there is no discount rate that results in a zero NPV. No IRR projects may have positive NPVs and can be good investments. However, because of unconventional cash flows, mathematically no IRR exists. The NPV profile of a project with no IRR does not intersect the x-axis.
Comparison between NPV and IRR
NPV | IRR |
Advantages | Advantages |
Direct measure of expected increase in value of the firm. | Shows the return on each dollar invested. |
Theoretically the best method. | Allows us to compare return with the required rate. |
Disadvantages | Disadvantages |
Does not consider project size. | Incorrectly assumes that cash flows are reinvested at IRR rate. The correct assumption is that intermediate cash flows are reinvested at the required rate. |
Might conflict with NPV analysis. | |
Possibility of multiple IRRs or no IRR for a project. |
Analysts and corporate managers should understand the logic and practicalities of different capital budgeting methods.
From financial textbooks perspective, NPV and IRR are superior techniques. However, companies also prefer other capital budgeting techniques, e.g., payback period.
Relationship between NPV and Stock Price
Example
A company is undertaking a project with an NPV of $500 million. The company currently has 100 million shares outstanding and each share has a price of $50. What is the likely impact of the project on the stock price?
Solution:
NPV of the project = $500 million. The overall value of company should increase by $500 million because of the project. Since there are 100 million shares outstanding, each share should go up by 500/100 = $5. The share price should increase from $50 to $55.