When capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its advantages and disadvantages.
With all other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often leads to the same conclusions. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. The main limitation of VSD is also its greatest strength: it uses a single discount rate for evaluating investments.
Although using one discount easier thing to evaluate, there are a number of situations that cause problems for IRR. If the analyst evaluates two projects, both of which share a common discount rate, predictable cash flows, equal risk and shorter time, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, to use a rate of return on t-bills over the last 20 years as the discount rate. One year t-bills returned between 1% and 12% In the last 20 years, so clearly the discount rate is changed.
Without modification, IRR does not account for changing discount rates, so it’s just not suitable for long-term projects with a discount that must be different. (To learn more, read the Discounted cash flow analysis, anything but ordinary: Calculating the present and future value of Annuities and investors need a good SSK.)
Another type of project for which a basic IRR calculation is ineffective is a project with a combination of several positive and negative cash flows. For example, consider a project for which the marketing Department needs to reinvent the brand every couple of years to stay in the current fashion market.
Project cash flows:
- 1 year = -$50,000 (initial investment)
- 2 years = $ 115,000
- 3 Year = $66,000 in new marketing it is to review the appearance of the project.
One VSD can not be used. Recall that IRR is the discount rate or the interest needed for the project to break even with initial investment. If market conditions change for many years, this project can have multiple IRRS. In other words, long designs with variations in cash flows and additional investments of capital may have several different meanings GNI.
The advantage of using the IRR method, the NPV for the example above is that NPV can handle multiple discount rates without any issues. Cash flow for each year can be discounted separately from the others makes the NPV, the better the method.
Another situation which causes problems for users of the IRR method is when the discount rate of the project is not known. In order for a VSD is the right way to evaluate the project, it needs to be compared with the discount rate. If IRR is above the discount rate, the project is feasible; if below, then the project is considered not feasible. If the discount rate is not known or cannot be applied to a specific project, for whatever reason, the IRR is of limited value. In cases like this, the NPV method above. If the NPV of the project is greater than zero, it is considered economically advantageous.
So, why is the IRR method still commonly used in capital budgeting? Its popularity is probably a direct consequence of its simplicity of reporting. The NPV method is very complex and requires assumptions at each stage, such as the discount rate or the probability of obtaining a monetary payment.
GNI method simplifies projects to a single number that management can use to determine whether the project is economically viable. The result is a simple, but for any project that represents a long-term process that has multiple cash flows at different rates of discount, or uncertain cash flows – in fact, for almost any project at all – ESP is not an effective assessment.
For more detailed information on capital budgeting, see the guide to Budgeting investment.