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Rakhi Vasavada
Rakhi Vasavada, Financial and Legal Consultant
Category: Finance
Satisfied Customers: 4451
Experience:  Graduated in law with Emphasis on Finance and have have been working in financial sector for over 12 Years
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Suppose a company has 5 different capital budgeting projects

Customer Question

Suppose a company has 5 different capital budgeting projects from which to choose, but has constrained funds and cannot implement all of the projects. Explain why comparing the projects' NPVs is better than comparing their IRRs.
Submitted: 5 years ago.
Category: Finance
Expert:  Rakhi Vasavada replied 5 years ago.

Dear Friend,


The internal rate of return (IRR) and net present value (NPV) are the two approaches which give similar results very often. But, in many projects it is observed that the internal rate of return is a less effective way of discounting the cash flows than net present value. The investment is measured and evaluated through internal rate of return by just discount rate only.


In many of the situations it is observed that IRR will have problems as it depends only on the discount rates. If two projects are evaluated simultaneously with same discount rates, similar income flow, same time period to check the profits and so on; it is easy to evaluate the project using IRR. But, discount rates usually differ over the period. For example, the rate of return varied from one percent to 12 percent over the range of around 20 years. So, here the discount rate is varying definitely.


IRR is also not effective for the projects which show often both positive and negative cash flows. If the investors have to look after the situation and reinvest for every two to three years, it will be ideally not good to evaluate the project using IRR. In case the project is made to run with changing discount rates then the method of evaluation called NPV will be better than IRR.


Looking to the above described reasons, comparing the projects' NPV is better than comparing their IRRs.


I hope this helps...

Warm Regards,

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