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Homework answers / question archive / Provide two circumstances where IRR should be avoided or replaced by NPV
Provide two circumstances where IRR should be avoided or replaced by NPV. Explain briefly
b) For projects with different lifetimes, how do we evaluate and make investment decision? Briefly explain.
c) Assume that you are valuing a project with the following expected cash flows. From Year 1 to Year 5, there will be a steady cash inflow of $50,000. At Year 6, it is expected that company will realize a cash outflow of $100,000. Cash inflows in Year 7 and 8 will be $20,000 and $10,000, respectively.
If the initial outlay (i.e., Year 0 cash flow) is $150,000 and the required rate of return is 10%, would you accept the project? Show your steps.
d) What is the payback period for the project in part (c).
a)Circumstances where IRR should be avoided or replaced by NPV:
IRR stands for internal rate of return. It estimates the profitability of potential investments using a percentage value rather than a dollar amount. It is also referred to as the discounted flow rate of return or the economic rate of return. It excludes outside factors such as capital costs and inflation.
NPV stands for net present value. It is expressed in a dollar figure. It is the difference between a company's present value of cash inflows and its present value of cash outflows over a specific period of time.
In the following circumstances IRR should be avoided or replaced by NPV:
While evaluating two projects, if both the projects share a common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR is suitable because the discount rate does not change substantially over short period of time. However, when the project period is longer, generally the discount rate keeps changing. IRR does not account for changing discount rates, so it's not adequate for longer-term projects with discount rates that are expected to vary.
Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which the marketing department must reinvent the brand every couple of years to stay current in a trendy market. If market conditions change over the years, this project can have multiple IRRs. In other words, long projects with fluctuating cash flows and additional investments of capital may have multiple distinct IRR values.
b)For projects with different lifetimes, the investment should be evaluated with the help of NPV analysis:
If mutually exclusive projects that are being analyzed don’t have the same lifetimes, the NPV analysis can be used. This is because NPV analysis considers a common point in time for all projects, which is the present time.
It is also important to know that for NPV analysis, different discount rates may cause different results and may change the ranking of the projects. Thus, the selected discount rate for such should be representative of the opportunity cost of capital for consistent economic decision-making.
c) NPV calculation :
| Year | Cash flow | Discounting factor @ 10% | Present value of cashflow |
| 0 | $ -1,50,000 | 1 | $ -1,50,000 |
| 1 | $ 50,000 | 0.9091 | $ 45,455 |
| 2 | $ 50,000 | 0.8264 | $ 41,322 |
| 3 | $ 50,000 | 0.7513 | $ 37,566 |
| 4 | $ 50,000 | 0.6830 | $ 34,151 |
| 5 | $ 50,000 | 0.6209 | $ 31,046 |
| 6 | $ -1,00,000 | 0.5645 | $ -56,447 |
| 7 | $ 20,000 | 0.5132 | $ 10,263 |
| 8 | $ 10,000 | 0.4665 | $ 4,665 |
| NPV | $ -1,980 |
As the NPV of the project is negative ($ -1980), the project should not be accepted.
d) Payback period
Present value of total cash outflow = $150000*1 + $100000*PVF(10%,6th year) = $150000 + ($100000*0.56447)= $206447
Payback period will fall in between year 4 and 5.
Payback period = year 4 + (206447-200000)*12/50000 = 4 years and 1.55 months
