IRR, payback, and other criteria
Besides NPV, managers use the internal rate of return, payback period, and profitability index. Each has strengths and pitfalls.
Internal rate of return
The internal rate of return (IRR) is the discount rate that makes NPV equal zero. The IRR rule accepts a project if its IRR exceeds the required return. IRR is popular because a percentage is intuitive to compare with borrowing costs or targets.
When IRR and NPV agree
For a normal project, with an initial outflow followed by inflows, IRR and NPV give the same accept-or-reject decision: if IRR exceeds the cost of capital, NPV is positive. Both use all cash flows and the time value of money.
IRR pitfalls
IRR can mislead. Projects with unconventional cash flows (for example, outflows later in their life) can have multiple IRRs or none. For mutually exclusive projects of different sizes or timing, the higher IRR is not always the better choice: a small project with a 30% IRR may add less value than a large project with a 20% IRR. NPV resolves these conflicts.
Modified IRR
The modified internal rate of return (MIRR) assumes cash flows are reinvested at the cost of capital rather than at the IRR itself, avoiding multiple IRRs and giving a more realistic rate. It is used by some firms to supplement NPV.
Payback period
The payback period is how long it takes for cash inflows to recover the initial investment. It is simple and highlights liquidity and risk, since quicker paybacks reduce exposure to uncertainty. But it ignores the time value of money (unless discounted payback is used) and all cash flows after the cutoff, potentially rejecting valuable long-term projects.
Profitability index
The profitability index (PI) = present value of future cash flows / initial investment. A PI above 1 means positive NPV. When capital is limited (capital rationing), ranking projects by PI helps choose the combination that maximises total NPV within the budget.
What firms actually use
Surveys of chief financial officers, such as Graham and Harvey's 2001 study, found that most large firms use NPV and IRR, often alongside payback. Smaller firms rely more on payback. Using several methods together can give a fuller picture, but NPV is the most reliable guide to value creation.
Worked example
Project A costs 10,000 and returns 13,000 after one year (IRR 30%, NPV at 10% about 1,818). Project B costs 100,000 and returns 120,000 after one year (IRR 20%, NPV at 10% about 9,091). If they are mutually exclusive, B adds more value despite its lower IRR, so NPV should guide the choice.
Key takeaways
IRR is the discount rate where NPV is zero; accept if it exceeds the required return. For normal projects IRR and NPV agree on accept or reject. IRR can mislead with unconventional cash flows or when comparing projects of different size or timing; prefer NPV. MIRR improves on IRR. Payback is simple but ignores time value and later cash flows. The profitability index helps under capital rationing. Most large firms use NPV and IRR.
Flashcard
Discount rate making NPV zero
Check your understanding
Why can choosing the project with the higher IRR be a mistake when projects are mutually exclusive?