NPV vs IRR
The net present value (NPV) and the internal rate of return (IRR) could as well be defined as two faces of the same coin as both reflect on the anticipated performance of a firm or business over a particular period of time. The main difference however should be more evident in the method or should I say the units used. While NPV is calculated in cash, the IRR is a percentage value expected in return from a capital project.
Due to the fact that NPV is calculated in currency, it always seems to resonate more easily with the general public as the general public comprehends monetary value better as compared to other values. This does not necessarily mean that the NPV is automatically the best option when evaluating a firm’s progress. The best option would depend on the perception of the individual doing the calculation, as well as, his objective in the whole exercise. It is evident that managers and administrators would prefer the IRR as a method, as percentages give a better outlook that can be used to make strategic decisions over the firm.
Another major shortfall associated with the IRR method is the fact that it cannot be conclusively used in circumstances where the cash flow is inconsistent. While working out figures in such fluctuating circumstances may prove tricky for the IRR method, it would pose no challenge for the NPV method since all that it would take is the collection of all the inflows-outflows and finding an average over the entire period in focus.
Evaluating the viability of a project using the IRR method could cloud the true picture if the figures on the inflow and outflow remain to fluctuate persistently. It may even give the false impression that a short term venture with high return in a short time is more viable as compared to a bigger long-term venture that would otherwise make more profits.
In order to make a decision between any of the two methods, it is important to take note of the following significant differences.
Summary:
1. While the NPV will work better in helping other people such as investors in understanding the actual figures in so far as the evaluation of a project is concerned, the IRR will give percentages which can be better understood by managers
2. As much as discrepancies in discounts will most likely lead to similar recommendations from both methods, it is important to note that the NPV method can evaluate big long-term projects better as opposed to the IRR which gives better accuracy on short term projects with consistent inflow or outflow figures.