I came over a question in the PM simulator and as well again in an online
, where I would not agree with the answer given in regards to IRR and NPV:
Based on the information provided below, which project would you recommend pursuing?
Project I, ...
Project II, with NPV of US $ 500,000;
Project III, with IRR (Internal rate of return) of 15%
Project IV, ...
Project III has an IRR of 15%, which means the revenues from the project equal the cost expended at an interest rate of 15%. This is a definitive and a favorable parameter, and hence can be recommended for selection.
Information provided on projects II and (...) is not definitive, and hence neither of projects II and(..) qualifies for a positive recommendation.
In my view this is not correct. The positive NPV indicates that today's (risk and time adjusted) value of the revenues exceeds today's (risk and time adjusted) value of the project cost by 500.000 - so this is as good as the IRR.
In fact, as an NPV calculation includes the required risk adjusted discounting rate, it contains more information than the IRR - as IRR does not provide any information about the required risk adjusted return. It could be that the project is highly risky, and therefore comparable investments would require higher return rates.
"(...) As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project (assuming no capital constraints).
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV. Apparently, managers find it easier to compare investments of different sizes in terms of percentage rates of return than by dollars of NPV. However, NPV remains the "more accurate" reflection of value to the business. IRR, as a measure of investment efficiency may give better insights in capital constrained situations. However, when comparing mutually exclusive projects, NPV is the appropriate measure."
If my assumption is correct, I would highly recommend you to sign in the simulator and post a comment on the actual question itself. You can go to your exam/quiz history and find the question that you don’t agree with. That will help us locate the question you are referring to, and hence provide a better response.
However, generally speaking any project with IRR of 15% is a great project. This means that loss would only happen if cash flows are discounted by anything over 15%, regardless of the investment. On the other hand is a project having NPV of $500,000 good or bad? That depends upon the investment. For an investment of $1,000,000 this is great. But what about if the initial investment is hundred million? So only knowing the NPV of any project is not sufficient to decide whether the project is worth investment or not, we also need to know the initial investment.
I would go for IRR as the best answer in this scenario if not the only correct answer. However, again I would recommend signing in the simulator and leaving your feedback on the actual question itself. That will give us the complete picture and help us provide you with an accurate response.
thanks for your reply. re the simulator, I posted my comments already there - I tried to find the question again, but was not successful (must be in Exam 1 through 4).
Re your response, I respectfully disagree. Choosing a rate of return like 15% and constitute that this is a great project is rather arbitrary - in some circumstances (think 15 years ago when interest rates were high, or think a company in distress) 15% would not cover cost of capital. The other way around is also possible - if you are able to lend money form the central bank risk free, than a "project" yielding an IRR of 0.5 % is terrific (as a lot of bankers can confirm these days...).
NPV overcomes this as it includes the risk-adjusted cost of capital the respective firm has to earn. In your example, assuming that the company is currently not well rated and has a financing cost of 15%, the project with 15% IRR would not be worthwhile to pursue (0% return, but incurring project risk), while the NPV-positive project would yield the 15% plus the 500 k.
Please note that it is not a solution to include interest cost into the IRR calculation as a cash outflow - it violates basic accounting guidelines.
In addition, IRR may lead to wrong project decisions in situations with constrained capital as well as in unconstrained situations. Consider a situation with two projects, while you are able to perform only one because of capital constraints. One has a higher IRR, but a smaller NPV due to its smaller size compared to the other. The company is worse choosing the higher IRR project, as the net cash flow (!) from the project is smaller - while the firm still has the same capital employed.
IRR is only in use as it seems (!) to be easier (NPV for the same project is different for different firms) - while its shortcomings are well documented.
Please also see a nice
of NYU university on this.
Your reasoning has a lot of weight in it and it has caused me to re-think. I will go ahead and search for the actual question. I will also request Mr. Cornelius Flitchner to share his expert opinion on this.
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