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Net Present Value Is Better Than Internal Rate of Return Asma Arshad ijcrb.webs.com DECEMBER 2012 INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS VOL 4, NO 8 Net Present Value is better than Internal Rate of Return Asma Arshad Management Studies Department “The University of Faisalabad”, Sargodha Road Faisalabad, Punjab, Pakistan. Abstract The main point behind this study was to analyze that NPV is better than IRR. As NPV is calculated on capital cost and IRR is determined on calculated IRR rate. For mutually exclusive projects NPV is preferable and for individual projects IRR is preferable. The main objective behind the study was to learn the existing system then reviewed preference of authors and after accessing the gap analyzed that either NPV is better or not. This quantitative and longitudinal study was conducted to test hypothesis. The 40 copy righted Google books were selected randomly, to categorize the data ordinal scale was used and then analyze the data by sum, mean and graphical presentation. These views were analyzed on individual basis and by categorizing under 10 different disciplines. Then found that 52.50% authors had the view that NPV is better Than IRR. Keywords: NPV, IRR, Better, Hypothesis testing, Disciplines, Sum, Mean, Quantitative study, Google books. 1. INTRODUCTION NPV is the net present value which is the sum of all the future cash flows to determine the present value. Cash flows include the both inflows and outflows that are discounted at a rate. It is calculated as: NPV = Cash inflows – Cash outflows or expenditure of Investment The net present value (NPV) of a project is the sum of the present value of all its cash flows, both inflows and outflows, discounted at a rate consistent with project’s risk. In this expression represent net cash flow in the year t, r is the discount rate and n represent the life of the project (Smart, Megginson, & Lucey, 2008). Net present value actually shows the sum of the present values in excess of its cost at some defined rate of interest or discount rate. It is calculated by applying the PV formula and at the end of computation of all PVs; then sum of all the values is done. Net present value is the excess of present value (PV) of future cash inflows to be generated by project over the amount of initial investment (I). The present values of future cash flows are computed using the so called cost of capital (or minimum required rate of return) as the discount rate (Shim Ph.D. & Siegel Ph.D., 2008). If the project shows the positive result then that project is accepted as net present value shows more value than the project’s initial cost. NPV describes the value of investment in amount but IRR shows the amount in percentage. IRR is the “Internal Rate of Return” which is used to determine that what rate of return an investor is taking on a project. IRR provides the answer in percentage. It is actually based on the present value concept; the amount of money which you receive today has more worth than you receive tomorrow. IRR is actually the capital budgeting technique which actually equates the NPV answer to the initial investment or cost. It can be calculated as; Here r is the rate of return on investment. Rate of return should be of that which will make the answer equal to zero. IRR describes what is the percentage return on my investment? IRR input include the amount and timing of cash invested in a project and the amount and timing of cash flow out. The percentage IRR provides is a hurdle rate; if the particular investment exceeds the investor’s threshold, it may be interest (Quatman II & Ranjit). COPY RIGHT © 2012 Institute of Interdisciplinary Business Research 211 ijcrb.webs.com DECEMBER 2012 INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS VOL 4, NO 8 1.1 IMPORTANCE OF THE STUDY IRR is used to evaluate that which one investment is providing comparatively better rate of return. Some investors prefer to use IRR as to take decision on the basis of required rate of return calculated in percentage. Financial managers prefer to use IRR. The preference for IRR is due to the general disposition of businesspeople towards rate of return rather than actual rupee return. They tend to find NPV less intuitive because it does not measure the amount relative to the amount invested (Gitman & Lawrence, 2008). But some investors prefer to use the NPV because it evaluates the investment project in amount. In amount or money value it is easily to understand that what a project is providing in return but in IRR it is difficult to evaluate. It is because the IRR gives answer in percentage which in many cases become difficult for investors to evaluate return. NPV project evaluation is superior to that of IRR. NPV discounts all the cash flows to present to see whether the investment project will cause benefit or loss to the investor (Don, Richard, Steve, Jhon, & Patrick, 2002). 1.2 OBJECTIVE OF THE STUDY NPV and IRR are the investment evaluation techniques used to evaluate which one project is giving better return. The main plan behind this study is to determine; i. To learn the on hand system of NPV and IRR. ii. Review the preference of authors to NPV than IRR. iii. Access the gap and facts between NPV and IRR. iv. To evaluate that NPV is better than IRR. 1.3 HYPOTHESIS = NPV is better than IRR. = NPV is not better than IRR. 2. REVIEW OF LITERATURE There are many reviews in favor of NPV and against IRR and vice versa. Some of these views are discussed here. Ed Wilson, the treasurer of an electronic firm, said that CFO and Managers used rate of return for selection of project that’s why firm goes with that project which will provide more rate of return. But Ed failed in describing how the NPV was better than IRR. Later on in the meeting of capital budget, Ed asked the professor to explain NPV was better than IRR. He explained through an example. A firm with adequate access to capital and 10% WACC was choosing between two equally risky and mutually exclusive projects. Project Large was calling for $100,000 and receiving $ 50,000 every year for 10 years. Project Small was calling for $1 and receiving .60 every year for 10 years (Appendix AI. and AII.). Project L Project s : $ 202, 703.90 : $ 2.43 : 49.1% : 59.4% Now IRR says choose S and NPV says choose L intuitively. It’s obvious that company would be off choosing a large project instead of lower IRR. Now with the 10% cost of capital (WACC) a project with 49.1% rate of return on $100,000 investment is more profitable than a project with 59.4% rate of return on $1 investment. Then Ed said that NPV is better than IRR because NPV will describe how much value will add, which is what the firm will maximize. Hence company switch to NPV from IRR (Brigham & Houston, 2009). On another side it was describes that NPV and IRR differ in two ways. First, NPV assumes that cash inflows are reinvested at required rate of return, whereas IRR assumes that cash inflows are reinvested at computed IRR. To reinvest at required rate of return is more realistic and provide reliable results when comparing mutually exclusive projects. Second NPV measures profitability in absolute manner and IRR measures in relative manner (Heitger, Mowen, & Hansen, 2007). On the other place it was also argued that in some cases IRR is better and in some cases NPV is better but concluded with superiority of NPV. For independent project NPV and IRR reaches the same result, if projects are mutually exclusive and different in size than NPV is best because it selects the project that maximizes the value. At conclusion it was said that NPV is better than IRR and MIRR for competitive projects (Brigham, Daves, & Daves, 2012). On another it was also illustrated that NPV is better than IRR but for mutually exclusive projects. Suppose there is a land which is suitable for two projects. One project is to grow grapes as land soil is more suitable. Second one is to be mined the land as it has minerals beneath it but both have same initial cost. Now just one project can be done. If the land has to dig then vineyard could not be possible and if land has to be mined then it cannot be use as vine yard. Now the NPV and IRR are calculated of both projects to take decision about mutually exclusive projects (AIII. and AIV.) COPY RIGHT © 2012 Institute of Interdisciplinary Business Research 212 ijcrb.webs.com DECEMBER 2012 INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS VOL 4, NO 8 Mining Project Vineyard Project : $ 59,752.17 : $ 232,843.44 : 16% : 15% From the project’s NPV and IRR it is cleared that NPV is better than IRR and investor will choose vineyard project with more NPV. Thus it’s cleared that for mutually exclusive project NPV is used to determine the profitability (Gallagher & Andrew, 2007). In another case it was shown that both NPV and IRR give same suggestions but it was only because of the cost of capital. Cost of capital also plays important role in ranking of project. Suppose there are two projects A and B. Both have the same initial cost of 105,000. Where cost of capital is 8% and when applied it was seen that project A has less NPV (23,970) than project B (25,455).
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