Financial managers and business owners typically prefer to estimate performance as a percentage rather than in dollars. As a result, they tend to favor capital allocation decisions expressed as percentages, such as the internal rate of return (IRR), instead of net present value (NPV) expressed in dollars.
What is the internal rate of return?
The internal rate of return is a way to express a project’s value as a percentage rather than in dollars. In financial terms, the internal rate of return is the discount rate or cost of capital for the company that makes the present value of the project’s incoming cash flows equal to the initial investment. This is similar to break-even analysis, where the net present value of the project is brought to equal 0 dollars. In other words, the internal rate of return is an estimate of the project’s rate of return.
Decision rules for internal rate of return
If the internal rate of return on the project is greater than or equal to the project’s cost of capital, the project is accepted. However, if the internal rate of return is less than the project’s cost of capital, the project is rejected. The logic behind this is that you never want to undertake a project for your company that returns less than the money you can pay to borrow it, i.e., the company’s cost of capital.
Net present value: better in some cases
Net present value (NPV) is often calculated using the discounted cash flow model, with each cash flow discounted separately, making it a more sophisticated analysis than internal rate of return analysis. If the rates of return change over the life of the project, NPV analysis can accommodate those changes. The NPV model also works better when the discount rate is not known, and as long as the NPV of the project is greater than zero, the project is considered financially viable.
Calculating net present value
Use the following formula to calculate the net present value of a project:
NPV = [Cash flow1 / (1 + r) + Cash flow2 / (1 + r)² + …] – X
Where:
Cash flowx = the expected cash flow for the project for each period (month, year, etc.)
r = the required rate of return, also known as the discount rate
X = the initial investment in the project, such as the cost of equipment
Conclusion
Everything suggests that the net present value decision-making method is better than the internal rate of return method. One of the problems with internal rate of return in capital planning is that the decision criteria for internal rate of return and net present value can provide conflicting answers in capital planning analysis. This can occur if any of the cash flows from the project are negative, other than the initial investment.
Another issue that business owners should also consider is the assumption of the reinvestment rate. The internal rate of return can sometimes be misleading because it assumes that the cash flows from the project are reinvested at the project’s internal rate of return. However, net present value assumes that the cash flows from the project are reinvested at the company’s cost of capital, which is the correct approach.
Source: https://www.thebalancemoney.com/irr-vs-net-present-value-392914
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