Should IRR Or NPV Be Used In Capital Budgeting?

Should IRR Or NPV Be Used In Capital Budgeting

Both internal rate of return (IRR) and net present value (NPV) can be used in capital budgeting to determine a project’s desirability and potential value. The former is expressed as a percentage, while NPV gives a dollar figure. Like most approaches, each has its benefits and drawbacks. But should IRR or NPV be used in capital budgeting? Let’s look.

What Is IRR?

Internal rate of return, which is also called the discounted flow rate of return, gives investors an idea of a project’s potential profitability. However, the term includes the word “internal” for a reason: it leaves out external factors like inflation and capital costs.

In short, if a project’s IRR turns out to exceed the organization’s required rate of return, or shows a net gain over time, you might want to go with it. By contrast, If the IRR drops under that rate or indicates a loss over time, you may want to pass.

What Are The Issues With IRR?

People commonly use IRR because the result is typically straightforward. But for long-term projects that have several cash flows at varying discount rates, or that have uncertain cash flows, IRR isn’t always the best gauge.

Also, IRR may not be the best metric for projects with a mix of positive and negative cash flows, such as those requiring rebranding every few years to remain current.

Another issue is when a project’s discount rate is unknown. That’s problematic because, to be relevant and effective, IRR requires comparison to a discount rate. Without a known discount rate, the IRR has limited value.

What Is NPV?

The net present value is essentially the difference between an organization’s current value of cash inflows and its current value of cash outflows over a certain period. As such, it provides an estimate of a project’s future cash flows. After that, the calculation uses a discount rate that represents the project’s capital costs and risks and reduces future cash flows into present value totals. Subsequently, future positive cash flows are transformed into one current value amount. 

At its essence, the NPV is the difference between a project’s cost and the income it produces.

What Are The Issues With NPV?

By its nature, the NPV approach is more complicated than IRR. It also necessitates assumptions at every stage about the discount rate or probability of cash payment.

Moreover, the cash flows and discount rate utilized in an NPV calculation commonly don’t account for all the prospective risks. Instead, it assumes the maximum cash flow values for each stage of the project. This can give investors false confidence.

Where Does NPV Shine?

The chief advantage of NPV over IRR is that it can easily handle multiple discount rates. Every year’s cash flow can be discounted apart from the others.

Where Does IRR Shine?

IRR gives investors a more holistic view of how profitable a project might be in comparison to alternative investments. It offers one of the best ways to understand whether you’ll get a good return on your investment.

Which Is Best, NPV Or IRR?

In capital budgeting, both metrics can be used to see whether a project will add value to an organization.  So, should IRR or NPV be used for capital budgeting? 

It depends. 

Some investors may prefer a dollar figure result over a percentage. In that way, NPV may be the better tool for decision making about new investments. On the other hand, NPV values are more difficult to calculate.  

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