Reasons could include:
- Interest lost- Any investment opportunity must make you wealthier than the returns that are available from the next-best opportunity. For example, investment in a project, i.e. machineries must have better than those from investing in the bank.
- Risk- A higher rate of return is expected from projects where the risk appears as being higher and thus how large the risk premium must be.
- Inflation- A general increase in the prices of goods and services in a country, which needs to be compensated to the investors for the loss of interest and purchasing power if the investment is to be made. This would be on top of a return that takes into account the returns that could have gained from an alternative investment of similar risk.
When evaluating real investment, we will have an expectation of cash flows over time. In NPV, we use the discount rate on the basis for the minimum return we will accept. If the NPV is positive, we accept the project, and if the NPV is negative, we reject the project.
IRR is quite closely related to the NPV method since it also involves discounting future cash flows. When applied to its future cash flows, it will produce precisely zero NPV.
It uses the iteration approach (trial and error) to be adopted. For any project to be acceptable, it must meet the minimum IRR, which tends to be the opportunity cost of finance. And where there are two or more projects involved, the one with the highest IRR should be chosen.
IRR is in many ways similar to NPV. However, it does have some problems. It ignores the real world, which therefore could lead to wrong decisions being made.
For example, if a situation had two projects, project A and Project B. Project A has a rate of return of 25 percent and project B has a rate of return of 20 percent, IRR would see project A as the best since it generates the most wealth.
On the other hand, assuming that the market rate has changed to 15 percent, than project B would be better than project A. But IRR does not see that, it ignores the scale of investment. Unlike NPV, NPV would be able to respond to the changes in the market rate.
Another problem could occur with the IRR method is if there are two negatives in the cash flow, as a result giving more than one IRR, we do not know which and whether the NPV is positive or negative between the two values. In order to find out, we must do the NPV calculation.
IRR is an average, in contrast to NPV, which can use a different discount rate for each year of the cash flow. NPV takes account of the time value of money.
I have come to the conclusion that the NPV method is a better method of appraising investment opportunities than the IRR method.
Reason being, although IRR has similar attributes to NPV, it has yet too many problems that could lead to a wrong decision being made, such as ignoring the real world and having multiple IRR’s in a situation.
Also, when coming to choose between two projects, the NPV method would be better and more reliable discriminator than to use IRR.
So in my opinion, I think that the NPV is the best method and therefore it should be the only method used in the investment appraisal.
