Why is NPV better than IRR?
Before starting a business or before an investment is made for a project, budget calculation for the capital amount should be done. To evaluate the project and predict its advantages and disadvantages in the future, there are several ways to work out. 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. The NPV is calculated using the formula:
NPV = Initial income + Income1/(1+IRR)1 + Income2/(1+IRR)2 +,¦,¦,¦.+ Income n/(1+IRR)n .
Where numbers adjacent to income represent the number of years and the IRR is also raised to the power of number of years since the project was running. It is important to keep the NPV value as zero or positive and not negative for a project to run smoothly or to accept a project. For doing this, IRR must be increased. In order to follow IRR method the business man should know the discount rate. If IRR is above the discount rate then the project can be continued. IRR method is not a reasonable way of evaluating the project. Hence, NPV method is better than IRR method.
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