Choosing the optimal criterion for ranking and selecting projects for an investment portfolio - NPV vs IRR

23/09/2019

All indicators for evaluating effectiveness of investment projects are closely interconnected and allow to evaluate their effectiveness from various sides. Therefore, during assessing the effectiveness of real investment projects they should be considered as a complex.

There is an obvious **relationship between NPV, PI, and IRR:**

- if NPV > 0, then simultaneously IRR > HR and PI > 1,
- if NPV < 0, then both IRR < HR and PI < 1,
- if NPV = 0, then simultaneously IRR = HR and PI = 1,

where HR (hurdle rate) is the barrier coefficient chosen by the company as the level of the desired return on investment.

- NPV is expressed as a monetary value, where IRR is expressed as a percentage.
- NPV is an absolute measure but IRR is relative. For example, if IRR = 20%, it means that the project may or may not be acceptable. The IRR is needed to be compared with the company's own acceptable rate of return. That's why IRR is a relative term.
- IRR is not used to evaluate a project in which cash flow changes over time. In such cases, NPV is more suitable as it takes into account each cash flow.
- In terms of long-term project the discount rate is likely to change, making IRR a less valuable financial indicator than NPV.
- Decision making is easier for NPV than IRR. In the case of NPV, any positive value (NPV> 0) is considered acceptable and may increase the value of the company. While the IRR is needed to be compared with acceptable rate of return, which makes the decision even more difficult.
- NPV takes into account any additional assets for calculating profitability, but the IRR method does not.
- When the initial investment is very high, NPV will show high cash flow. In this case the IRR will show the best result, since it reflects interest income regardless of the initial cash flow.
- Financial analysts prefer IRR in short-term individual projects, but they prefer NPV for long-term mutually exclusive projects.

The conflict itself can be described in just a few words: the ranking of several investment projects by IRR and NPV does not always coincide.

Name of project | Project Alfa | Project Beta |

Discount rate | 10% | 15% |

0 | -1 000 | -5 000 |

1 | 300 | 2 000 |

2 | 500 | 2 200 |

3 | 700 | 2 420 |

4 | 900 | 2 662 |

5 | 1 100 | 2 928 |

NPV | 1 510 | 2 972 |

IRR | 47% | 36% |

One of such cases is presented in the table. The second project has a larger NPV, but less IRR.

Generally, NPV is a better financial tool for capital budgeting as it takes into account the variation in cash-flow, discount rate and additional wealth which sounds more theoretical and realistic. But we recommend to make desicion about the best indicator evaluating effectiveness of investment projects takking into account project specialty, duration and other special characteristics. The overall concept is to use both indicators (NPV and IRR) and to make correct desicion to include both into desicion making process regarding project acceptance or to exclude one.