Relationship between NPV and IRR

The net present value (NPV) and the internal rate of return (IRR) methods are two closely related investment criteria. Both are time-adjusted methods of measuring investment worth. In case of independent projects, two methods lead to same decisions. However, under certain situations (to be discussed later in this section), a conflict arises between them. It is under these cases that a choice between the two criteria has to be made. A single project will be accepted if it has a positive NPV at the required rate of return. If it has a positive NPV then, it will have an IRR that is greater than the required rate of return.

We have shown that the NPV and IRR methods yield the same accept-or-reject rule in case of independent conventional investments. However, in real business situations there are alternative ways of achieving an objective and, thus, accepting one alternative will mean excluding the other. Two projects are mutually exclusive if only one of the projects can be undertaken. In this circumstance the NPV and IRR may give conflicting recommendation. The reasons for the differences in ranking are:

  • NPV is an absolute measure but the IRR is a relative measure of a project’s viability.
  • Reinvestment assumption. The two methods are sometimes said to be based on different assumptions about the rate at which funds generated by the project are reinvested. NPV assumes reinvestment at the company’s cost of capital, IRR assumes reinvestment at the IRR.

Since the NPV and IRR rules can give conflicting ranking to mutually exclusive projects, one cannot remain indifferent as to the choice of the rule.

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