Evaluation of net present value

Question

Explain evaluation of net present value (NPV) and internal rate of return (IRR) in brief?

Answer 1

The evaluation of net present value (NPV) and internal rate of return (IRR) is well developed and documented in many publications, some representative ones of which are Muro’s and Lang and Merino’s. IRR and NPV are the most common and important indicators in investment decisions. Although ARR (accounting rate of return), as reported by Lefley, is also a common indicator, whose role was fully discussed by Brief and Lawson, both Muro and Lefley and Morgan opined that ARR has shortcomings and that the discounted cash flow methods, such as IRR and NPV, the so-called more “sophisticated” and “scientific” methods, should be preferred in capital investment appraisals.

Although IRR and NPV both are discounted cash flow methods, they have intrinsic differences from one another. Tang and Robinson and Cook illustrated that the ranking of investment alternatives is not necessarily the same obtained by the two methods. Differences in rankings between NPV and IRR are further exhibited in Asquith and Bethel, who reported that IRR might be preferred to NPV under certain circumstances. Evans and Forbes also reckoned that IRR is more cognitively efficient than NPV because IRR is expressed as a percentage (or a rate of return) while NPV was just a monetary value cognitively inefficient to decision makers, and hence the use of IRR should be promoted. Other researchers, such as Lefley and Morgan, and particularly the academicians, however, took the view that NPV is more conceptually “correct” despite the fact that the IRR is more popular than the NPV, and that NPV is more theoretically sound as the IRR may be too “capricious” or “fickle” and may not rank some projects in the same order as the NPV.

The definition is: IRR gives the private investor’s point of view and NPV the society’s point of view. In other words, the IRR is a financial indicator and the NPV, an economic indicator. Because the IRR functions as a financial indicator, its value varies with the change of financial arrangements (e.g. change of equityloan ratio, change of taxation rate, etc.) of a capital investment. The NPV, however, does not vary when financial arrangement varies, because it functions as an economic indicator. In this paper, the authors will use an illustrative example to show the basic differences of IRR and NPV. They will also show a mathematical proof to substantiate these intrinsic different natures of the IRR and the NPV.