NPV vs. IRR

[vaibhav]

Hi guys,

Suppose we need to decide between two mutually exclusive investments i.e. we can either reject both or select one of either but not select both. Now if if NPV of X is higher than NPV of Y but IRR of X is lower than that of Y, in that case we chose NPV criteria and accept X.

For example:
Investment Cash inflow at t = 1 IRR NPV@10%
Y - 5000 8000 60% 2272.72
X - 30000 40,000 33% 6363.64

The reason for going for NPV criteria is that it indicates the increase in shareholder's wealth. Like in above case the shareholders will gain more if investment X is made though the IRR is lesser.

Another explanation for going for preferring NPV criteria over IRR criteria is because NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost fo capital whereas the IRR method assumes that the firm can reinvest @ IRR.

Can somebody explain to me how the above mentioned italicized explanation ?

Thanks in advance

Vaibhav.

 

[testami]

NPV is the way to go because it increases your absolute dollar wealth the most.

Would you rather make:

20% on a 1,000 investment (project A)
--or--
10% on a $1,000,000 investment (project B)

....project A has the higher IRR (20% vs. 10%) but only adds $200 to your bank account. Project B adds $100,000.....so it would be more attractive.

Also, although project A may yield a 20% return on this one project, it has nothing to do with market rates so you can't assume you reinvest your $200 into another project any make another 20%.

Let's say market rates are 8%. After one year:

project A has returned $200 that can now be invested at 8% ($16 interest)
project B has returned $100,000 that can now be invested at 8% ($8,000 interest).

 

[vaibhav]

Thanks testami for a wonderful lucid explanation. I got it all clear.

Regards

Vaibhav