Capital Budgeting - NPV > IRR

When deciding whether to accept or reject a single project, the NPV and IRR methods give identical recommendations because if the IRR is higher than the cost of capital, the NPV will automatically be positive.

However, in practical, a company has limited fund to develop or invest. It is the intention for the company to earn maximize cash flow from the investment. Therefore, the company will rank the potential projects.

For ranking competing projects, the NPV method is generally preferred over the IRR method. IRR method can give incorrect rankings, particularly when the projects are of different sizes, because it measures the rate of return rather than the absolute gain that each project offers the company. A high rate of return on a small project can be worth less than a lower rate of return on a big project.

Also, the IRR method can sometimes result in multiple internal rates of return, or sometimes it is not possible to find any IRR at all.

For example, there are two potential projects with initial layout of $1 million. The company has $1 million available cash for investment and therefore only one project can be choose. Details of projects are as follows:

Year---Project 1----------Project 2
1-------0--------------------370,000
2-------200,000-----------370,000
3-------600,000-----------370,000
4-------900,000-----------370,000

NPV calculation (assume discount rate is 12%)
Year---Project 1----------Project 2
0-------(1,000,000)------(1,000,000)
1-------0-------------------330,410
2-------159,400----------294,890
3-------427,200----------263,440
4-------572,400----------235,320
NPV--159,000----------124,060

The NPV of project 1 is higher than that of project 2 and should be selected. However, if use IRR, the IRR of project 1 is 17% but the IRR of project 2 is 17.8%. Under IRR, project 2 is selected but the NPV is less than project 1. The Company cannot maximize its wealth.