1.30 The NPV vs. the IRR: Differences in Methodologies (Summary and Review)
NPV:
- Use of the firm’s “cost of capital” as the discount rate.
- We may think of the cost of capital as an external rate, i.e., external to the formula.
- For now, the cost of capital has been “given.”
- Accept only those projects whose NPV > $0; reject all others.
- If given two or more competing, or “mutually exclusive,” projects, choose that project, which provides the highest NPV (assuming its NPV > $0).
IRR:
- Calculate the IRR through an “iterative,” Trial and Error process.
- If the initial NPV > 0, you must raise the discount rate.
- The discount rate, where NPV = 0, is the IRR
- Choose only those independent projects whose IRR exceeds the stated cost of capital;
- This also means that NPV > 0
- If given mutually exclusive projects, choose that project which has the highest IRR (provided the IRR exceeds the firm’s cost of capital)
Note:
Let’s say that at a 10% cost of capital / discount rate, a project’s NPV is $1,000. In order to get the NPV “down” to zero, the rate must be raised. Thus, if a project’s IRR exceeds the firm’s cost of capital, the project’s NPV, using the cost of capital as the discount rate – mathematically – must be positive.