NPV versus IRR

[gradesupport]

I am having a tough time making sense of IRR. If a project has a better Internal Rate of Return than another project, why do people still choose the one with a lower return? I get that NPV matters but aren't investors usually focused on returns - after all NPV is just an estimation of future value. For example, Project A) has NPV of $1000, and IRR of 12.0%, Project B) has NPV of $1050 and IRR of 7%, which project is better financially speaking?

 

[stapel]

I am having a tough time making sense of IRR. If a project has a better Internal Rate of Return than another project, why do people still choose the one with a lower return? I get that NPV matters but aren't investors usually focused on returns - after all NPV is just an estimation of future value. For example, Project A) has NPV of $1000, and IRR of 12.0%, Project B) has NPV of $1050 and IRR of 7%, which project is better financially speaking?

If you are asking for information regarding the differences between "Internal Rates of Return" and "Net Present Values", then please try here. If, on the other hand, you are asking for assistance with the "For example" homework problem, then please reply with a clear listing of your thoughts and efforts so far.

Thank you!

 

[gradesupport]

Thanks for the direction Stapel. I still need a bit of assistance as I do not believe there is any other step to comparing the options. Ie. no calculations. How can project B be a better choice if the rate of return is lower?


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[stapel]

Thanks for the direction Stapel. I still need a bit of assistance as I do not believe there is any other step to comparing the options. Ie. no calculations. How can project B be a better choice if the rate of return is lower?

Did you read any of the articles at the link? Such as articles discussing the differences between the two measures, including how they're used? This information may prove helpful.

 

[JeffM]

I am having a tough time making sense of IRR. If a project has a better Internal Rate of Return than another project, why do people still choose the one with a lower return? I get that NPV matters but aren't investors usually focused on returns - after all NPV is just an estimation of future value. For example, Project A) has NPV of $1000, and IRR of 12.0%, Project B) has NPV of $1050 and IRR of 7%, which project is better financially speaking?

NPV represents a VALUE based on a rate at which cash flows can be invested independent of the rate of return on the investment itself (an external rate) whereas IRR represents a RATE that assumes all cash flows are invested at the same rate as the initial investment (an internal rate).

If the two measures give the same answer, most people tend to stop the analysis. If the two measures disagree, most people tend to make a judgement about which assumption seems more plausible. A more sophisticated method is to calculate a single breakeven reinvestment rate. If you want to be super-sophisticated, you skip all three methods in favor of a Monte Carlo analysis of different reinvestment rates during different periods. In any case, each method depends on assumptions about the future so, unless you are God, whatever method you use may be wrong. What that means in practice is that as the analyst you will be the one fired if the future turns out to be quite different from what you assumed.

 

[gradesupport]

Thanks everyone for the help. You folks are great! Investopedia helped a lot, especially the capital budgeting quote about IRRs use which "lies in its ability to represent any investment opportunity's return and to compare it with other possible investments". So as Jeff stated it depends what your firm is constrained on, value or high Rates of return. Cheers,


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