Answer First
NPV is better than IRR because NPV directly measures value creation in dollars, while IRR can give misleading rankings when projects differ in scale, timing, or cash flow patterns. NPV always leads to the correct decision for maximizing firm value.
Problem Setup
The NPV rule: \[ \text{Accept if } NPV > 0. \] The IRR rule: \[ \text{Accept if } IRR > r. \] Both evaluate the same cash flows, but they behave differently under real‑world conditions.
Step-by-Step Explanation
1. NPV measures value directly
NPV tells managers exactly how much value a project adds in today’s dollars. IRR only gives a percentage return, which can be misleading.
2. IRR fails when projects differ in scale
A small project may have a high IRR but add little value. A large project may have a lower IRR but create far more total value.
3. IRR fails when cash flows are unconventional
If cash flows switch signs more than once, IRR can produce:
- multiple IRRs, or
- no IRR at all.
NPV always works.
4. IRR fails when comparing mutually exclusive projects
IRR ranks projects by percentage return, not by total value created. NPV ranks them correctly.
5. IRR assumes reinvestment at IRR
This is unrealistic. NPV assumes reinvestment at the discount rate, which is consistent with market conditions.
Intuition
IRR tells you the “speed” of return. NPV tells you the “amount” of value created. Managers care about value, not speed.
Common Exam Mistakes
- Choosing the project with the highest IRR instead of highest NPV.
- Using IRR when cash flows are unconventional.
- Ignoring scale differences between projects.
- Forgetting that IRR can produce multiple answers.
Final Summary
NPV is better than IRR because it always leads to the value‑maximizing decision. IRR can mislead managers when projects differ in scale, timing, or cash flow patterns. NPV is the gold standard for capital budgeting.
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