NPV vs IRR Methods¶

Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include:

• NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return;

• Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;

• The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);

• However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,

• While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash.

• Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recomendation.


Recent variations of these methods include:

• The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields; it is designed for firms with active debt and a consistent market value leverage ratio;

• The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment; this method tends to favor smaller projects and is best used by firms with limited resources and high costs of capital;

• The Bailout Payback Method, which is a variation of the Payback Method, includes the salvage value of any equipment purchased in its calculations;

• The Real Options Approach allows for flexibility, encourages constant reassessment based on the riskiness of the project's cash flows and is based on the concept of creating a list of value-maximizing options to choose projects from; management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary; it is noteworthy that there is not a lot of support for this method among financial managers at this time.