The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems

The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others.

Ben-Horn and Kroll (2012) suggests that the problem of multiple IRRs is highly unlikely to occur in cash flow structures that have basic economic appeal to practitioners. From a practical point, an investment project should have a positive NPV at zero cost of capital.

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Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. If a 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 is superior.

Plath and Kennedy (1994) discuss the traditional teaching of discounted cash flow measures of capital project evaluation. The problem being that business school graduates remain unconvinced that NPV is a superior measure and surveys show a wide use of IRR and increasing use as the availability of IRR, MIRR algorithms and computer software products make it easier for analysts with no advanced training to use.

Chen (2012) discusses the Graham and Harvey (2001) survey where 392 CFO’s from US firms were surveyed regarding the practice and cost of capital, capital budgeting, and capital structure. This survey showed that IRR was most frequently used in capital budgeting at 75.61% as opposed to NPV at 74.93%. Also the size of the firm was relevant; with larger firms favouring NPV and IRR and smaller firms relatively preferred payback method.

Ryan and Ryan (2002) survey of 250 CF0 found the most preferred technique to be NPV followed by IRR. This survey also identified that geography was relevant in the decision with Europe preferring the payback period to NPV or IRR.

Conclusion

“The IRR rule is redundant as an investment criterion because the net present value (NPV) rule always dominates it.”

Research evidence supports the popularity of NPV but also shows that NPV is not the only preferred way to evaluate investment viability. The IRR method is still commonly used in capital budgeting and its popularity is probably a direct result of its reporting simplicity.

Advantages

• NPV advantage is that it is a direct measure of the pound contribution to the stockholders

• IIR advantage is that is shows the return on the original money invested

Disadvantages Hazen (2003)

• NPV disadvantage is that the project size is not measured.

• IRR disadvantage is that at times it can give conflicting answers when compared to NPV for mutually exclusive projects. The multiple IRR problem can also be an issue

The evidence concludes that both NPV and IRR are popular investment evaluations methods and both are used despite the disadvantages researched and published. Both are useful and as such have been described as companions.

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