Every business at some stage has to evaluate projects or investments and choose the ones that will benefit the business most.
Usually, it will be faced with a limited budget and spending this capital wisely is critical.
This process is called capital budgeting and the most used decision making tools are the Net Present Value (NPV) and the Internal rate of return (IRR).
I have described these 2 tools and how to use them previously – for NPV http://bit.ly/1dp3nVe and for IRR http://bit.ly/1jLg5p8
So which is the best tool to use? In simple terms, both should be used since both can give different answers sometimes. So let’s look at an example where this happens, which will help summarise the pros and cons of each method.
Say Project A has an initial capital outlay of £250,000 with net cash inflows of £50,000 in year 1 and net cash inflows of £100,000 from years 2 to 5. Project B has an initial capital outlay of £50,000 with net cash inflows of £10,000 in year 1 and net cash inflows of £25,000 from years 2 to 5. The resulting NPVs using a discount rate of 10% and IRRs are as follows:
Calculating the NPV and IRR for each gives differing answers. Project A has a higher NPV whilst Project B has a higher IRR. The simple reason for the higher IRR this is that Project B has a higher return based on the initial investment and the investment pays back sooner. So the project size and timing of cash flows cash result in conflicting answers from NPV and IRR methods.
So which one to choose ? All things being equal on risk, the business should choose Project A since it adds a larger financial value to the business.
Once you understand the above, the following pros and cons emerge for NPV and IRR.
1. Gives a net present value currency amount for a project which reflects the financial value added to the business
2. More meaningful indicator for decisions
3. Takes into account the time value of money
4. Takes into account the risk of future cash flows
5. Takes negative cashflows in middle of a project into account, i.e. if a project makes a loss in the middle of the forecast periods
1. The cost of capital also known as the discount rate for the business maybe difficult to calculate with accuracy
2. Differing discount rates will give different answers
3. Project size is not measured
1. IRR shows the original return on the money invested
2. IRR is the rate at which all present values of the project cashflows equate to zero, i.e. break even point
3. No need to calculate the cost of capital for the business
4. Gives the rate that is the minimum required as the cost of capital rate, so risk can be further evaluated
1. Can give multiple rates if the there are negative cashflows in the life of a project
2. Gives a rate of return rather than the value of a project in currency terms
To summarise, I would advise the following when using these tools:
1. Use both tools whenever possible
2. Also look at the discounted payback period – the faster payback the better
3. Evaluate the risks of each project
4. Use the IRR as the minimum hurdle and check if a higher rate still produces a positive NPV
5. If the NPV for a project is negative, don’t undertake it (you will destroy shareholder value)
6. Always measure the actual results of a project to the forecasts so that you learn where you went wrong with the original analysis