Corporate Finance - Advantages and Disadvantages of the

NPV and IRR Methods

While useful NPV and IRR methods are useful methods for determining
whether to accept a project, both have their advantages and
disadvantages.

Advantages:
With the NPV method, the advantage is that it is a direct
measure of the dollar contribution to the stockholders.
With the IRR method, the advantage is that it shows the return
on the original money invested.
Disadvantages:
With the NPV method, the disadvantage is that the project size
is not measured.
With the IRR method, the disadvantage is that, at times, it can
give you conflicting answers when compared to NPV for mutually
exclusive projects. The 'multiple IRR problem' can also be an
issue, as discussed below.
The Multiple IRR Problem
A multiple IRR problem occurs when cash flows during the project
lifetime is negative (i.e. the project operates at a loss or the company
needs to contribute more capital).

This is known as a "non-normal cash flow", and such cash flows will
give multiple IRRs.

Why Do NPV and IRR Methods Produce Conflicting Rankings?
When a project is an independent project, meaning the decision to
invest in a project is independent of any other projects, both the NPV
and IRR will always give the same result, either rejecting or accepting
a project.

While NPV and IRR are useful metrics for analyzing mutually exclusive
projects - that is, when the decision must be one project or another -
these metrics do not always point you in the same direction. This is a
result of the timing of cash flows for each project. In addition,
conflicting results may simply occur because of the project sizes.
Look Out!
The timing of cash flows as well as project sizes can produce conflicting
results in the NPV and IRR methods.
Example: NPV and IRR Analysis
Assume once again that Newco needs to purchase a new machine for
its manufacturing plant. Newco has narrowed it down to two machines
that meet its criteria (Machine A and Machine B), and now it has to
choose one of the machines to purchase. Further, Newco has assumed
the following analysis on which to base its decision:

Figure 11.6: Potential Machines for Newco


Answer:
We first determine the NPV for each machine as follows:

NPV
A
= ($5,000) + $2,768 + $2.553 = $321
NPV
B
= ($10,000) + $5,350 + $5,106 = $456

According to the NPV analysis alone, Machine B is the most appropriate
choice for Newco to purchase.

The next step is to determine the IRR for each machine using our
financial calculator. The IRR for Machine A is equal to 13%, whereas
the IRR for Machine B is equal to 11%.

According to the IRR analysis alone, Machine A is the most appropriate
choice for Newco to purchase.

The NPV and IRR analysis for these two projects give us conflicting
results. This is most likely due to the timing of the cash flows for each
project as well as the size differential between the two projects.

The Post-Audit's Role
The post-audit process in the capital-budgeting process is quite
important. In the post-audit process, an analyst examines a company's
capital-budgeting decisions to see how the actual results from the
projects compare to the results the company estimated. The post-audit
process gives the company a sense of not only how the projects are
performing, but also how good its inputs were.

If a project's actual results differed significantly in a negative direction,
the post-audit process will help the company learn where it went
wrong with respect to inputs so that the same mistake will not be
made when analyzing future projects.