Net Present Value (NPV) Method Versus Internal Rate of Return (IRR) Method:
Learning Objectives:
 What is the difference between net
present value (NPV) method and internal rate of return (IRR) method?
The net present value (NPV)
method has several important advantages over the internal rate of return
(IRR)
method. First the net present value method is often simpler to use. As
mentioned earlier, the internal rate of return method may require hunting
for the discount rate that results in a net present value of zero. This can
be a very laborious trialanderror process, although it can be automated to
some degree using a computer spreadsheet.
Second, a key assumption made by the
internal rate of return (IRR) method is questionable. Both methods assume that
cash flows generated by a project during its useful life are immediately
reinvested elsewhere. However, the two methods make different assumptions
concerning the rate of return that is earned on those cash flow. The net
present value method assumes the rate of return is the discount rate,
whereas the internal rate of return method assumes the rate of return is the
internal rate of return on the project. Specifically, it the internal rate
of return of the project is high, this assumption may not be realistic. It
is generally more realistic to assume that cash inflows can be reinvested at
a rate of return equal to the discount rate  particularly if the discount
rate is the company's cost of capital or an opportunity rate of return. For
example, if the discount rate is the company's cost of capital, this rate of
return can be actually realized by paying off the company's creditors and
buying back the company's stock with cash flows from the project. In short,
when the net present value method and the internal rate of return method do
not agree concerning the attractiveness of a project, it is best to go with
the net present value method. Of the two methods, it makes the more
realistic assumption about the rate of return that can be earned on cash
flows from the project.
