The NPV method leads to shareholder value maximization and is preferable to the IRR technique for several reasons.* One advantage of the NPV method is that it’s expressed in dollars, not in percentages. Therefore, we can sum NPVs of individual projects to calculate an NPV of a combination or portfolio of projects. In contrast, the IRRs of individual projects cannot be added or averaged to represent the IRR of a combination of projects.
A second advantage of NPV is that it can be expressed as a unique number. From the sign and magnitude of this number, the firm can then make an accurate assessment of the financial consequences of accepting or rejecting the project. Under the IRR method, it is possible that more than one IRR may exist for a given project. In other words, there may be multiple discount rates that equate the NPV of a set of cash flows to zero. This is the case, for example, when the signs of the cash flows switch over time; that is, when there are outflows, followed by inflows, followed by additional outflows, and so forth. In such cases, it is difficult to know which of the IRR estimates should be compared to the firm’s required rate of return.
A third advantage of the NPV method is that it can be used when the RRR varies over the life of a project. Suppose Vector’s management sets an RRR of 10% per year in years 1 and 2 and 14% per year in years 3, 4, and 5. Total present value of the cash inflows can be calculated as $633,780 (computations not shown). It is not possible to use the IRR method in this case. That’s because different RRRs in different years mean there is no single RRR that the IRR (a single figure) can be compared against to decide if the project should be accepted or rejected.
Finally, in some situations, the IRR method is prone to indicating erroneous decisions. This can occur when mutually exclusive projects with unequal lives or unequal levels of initial investment are being compared to one another. The reason is that the IRR method implicitly assumes that project cash flows can be reinvested at the project’s rate of return. The NPV method, in contrast, accurately assumes that project cash flows can only be reinvested at the company’s required rate of return.
Despite its limitations, the IRR method is widely used.* Why? Probably because managers find the percentage return computed under the IRR method easy to understand and compare. Moreover, in most instances where a single project is being evaluated, their decisions would likely be unaffected by the choice of using IRR or NPV.