Which method do you think is the better one for making capital budgeting decisions – IRR or NPV? Why?
as you probably already know, the IRR is the interest rate at which the NPV is zero, and therefore the two are related. Academically NPV is considered the better option because it is correct 100% of the time. IRR on the other hand, makes short term projects look more attractive and can even make projects with a negative NPV look attractive and vice versa. “When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate — sometimes very significantly — the annual equivalent return from the project. The formula assumes that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows. In this case, the calculation implicitly takes credit for these additional projects. Calculations of net present value (NPV), by contrast, generally assume only that a company can earn its cost of capital on interim cash flows, leaving any future incremental project value with those future projects.”
