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Economics: IRR vs. NPV

  1. Dec 8, 2008 #1
    Hello,

    I've had an intro economics course recently and there are still a couple of questions unanswered.

    One of the examples given where a handfull of projects with an initial investment and positive cash flows the following years. The question was which project is preferable when looking at IRR, NPV and a couple of other tools.

    It was decided that the first two methods where most important and that project A and C looked most promising. Both had the same initial investment.
    A: high first cashflow, moderate cashflow for a few years, then none anymore
    C: low but stable cashflow throughout into the future

    A: IRR ~13% NPV ~18
    C: IRR ~10% NPV ~23

    I only wrote down a few advantages and disadvantages for both methods and the remark that project A is preferable to C. The question is why? The IRR I learnt cannot be used for ranking across projects and the NPV is lower. Maybe because the initial investment is paid back quicker or are there other arguments for that? I know I should have asked the lecturer, but he was speeding so quickly through his slides that I just tried to keep up with taking notes and id not really think about what he was saying.

    Thanks a lot for any hints.
    M.
     
  2. jcsd
  3. Dec 8, 2008 #2

    BWV

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    Many will say that this is because IRR assumes reinvestment at the IRR rate, but it is not quite correct. However, for projects with large early cashflows it will be overstated relative to NPV. The basic idea is that one would rather have an investment that compounded at 15% for ten years than one that returned 20% in one year and then would have to be re-invested.
     
  4. Dec 8, 2008 #3

    CRGreathouse

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    This page has a good explanation:
    http://hspm.sph.sc.edu/COURSES/ECON/Invest/invest.html

    In essence, the IRR reports the discount rate at which the NPV would be zero, but it's hard to compare investments on the basis of IRR only if the relative timings of payments differ significantly, because the NPV zero point may not tell much about the value at other discount rates.
     
  5. Dec 9, 2008 #4

    stewartcs

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    If by IRR you mean Incremental Rate of Return and not Internal Rate of Return, then you'll select the project that has an IRR greater than your MARR. When comparing projects one typically uses Incremental Analysis to determine which one maximizes the NPW of the alternatives.

    CS
     
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