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NPV or IRR?

Why not both?


T.F.TnRRlES
tiple root problems as does IRR.
The merit measures most com'T.F. Torries, member SME,is prolessor with ihe Uivision 01
Consequently, there is no reason
monly used by industry financial ariaAEsOUI
C
~
Mana~tment.
West
Virginia
University,
Moroanlown.WV.
not
to
use both NPV and IRR.
lysts to determine investment feasiThese conclusions do not in any
bility include net present value Preprinl91-034, presented at the !ME Annual Meeting, feb. 24-27.
1997. Oenver, En. Aevised m a n ~ ~ c received
t i ~ t lor prlblication
way denigrate the use and impor(NPV) and internal rate of return
(IRR), plus the derivatives of these March 1998. Oiscussion 01 this peer-reviewed and auuroved paper tance of NPV as a merit measure.
is invited and must be submitted 10 SME prior 10 Jan. 31.1999
They simply suggest that it is not imtwo measures such as net future value
proper and that it is sometimes useful
(NFV) and benefit t o cost ratio. All
to use IRR as a merit measure as well.
engineering economics textbooks acIt is important to note that IRR is one of the most frecept that either NPV or IRR can be used to select the
quently used and misused measures of project feasibility
most economically desirable projects under conditions
and is also one that is explained in the most confusing
of budgetary constraints or where the projects are mutumanner by academicians. Consequently, the purpose of
ally exclusive. This is accomplished by choosing the mix
this paper is to clarify the usefulness of IRR relative to
of projects wit11 the highest NPV or IRR, as long as:
NPV.
budgetary constraints are met,
Definitions of NPV and IRR
IRR is greater than the minimum acceptable rate of
NPV and I R R are related, but they are different
return (UMARR) and
merit measures of investment feasibility. IRR is a meaIRR is determined correctly.
sure of the rate at which capital is accumulated, as opposed to NPV, which is a measure of a stock of wealth.
Most engineering economics textbooks also suggest
Each measures a different aspect of the desirability of a
that NPV is a preferred merit measure over I R R beproject, i.e., return on capital invested and amount of
cause maximizing NPV is more consistent with economic
wealth accumulated. IRR and NPV are related in that, as
theory and because IRR has problems associated with
the discount rate increases for a specific cash flow, NPV
multiple root solutions and reinvestment assumptions.
of the cash flow decreases. This leads
Also, texts propose that a complex
methodology called incremental
t o the definition of IRR as that disanalysis is necessary to correctly de- Abstract
count rate that makes NPV equal
The primary criteria used by zero. An alternative definition of IRR
termine IRR.
This paper questions the premise the mining industry to judge the is the rate that equates the initial inthat NPV is always the preferred merit of aproject is internal rate oj vestment with the future value of the
merit measure over I R R and con- return (IRR) rather than net resulting cash flows. The higher the
cludes that, while NPV does give suf- present value (NPV), although IRR, the more profitable is the
ficient information to make financial NPV is favored by academicians. project in terms of return on invested
decisions:
This paper discusses the problems capital. IRR is, therefore, determined
of IRR and NPVand compares the internally as compared to the disI R R gives investors additional multigoal nature of the decision- count rate for NPV, which is deteruseful information that NPV makers and their needfor informa- mined externally.
does not,
tion having the characteristics oj
Maximization of utility or wealth,
more information is preferred by NPV and IRR. The conclusions as represented by NPV, is the theodecision-makers rather than less, reached are that both NPV and retically correct investment-ranking
I R R is sometimes the more ap- I R R can be used for investment criteria from an economic perspecpropriate merit measure,
ranking, that NPVsujffers the same tive. However, there are three addithe reinvestment or ranking char- multiple root problem as does tional considerations. First, investors
acteristics of NPV and I R R d o IRR, and the use of conventional usually have more than a single goal,
not make one merit measure su- incremental I R R to reach NPV- as described in Baumo1(1965), Evans
perior to the other and
consistent project ranking is mis- (1984), Walls (1995) and Walls and
NPV suffers from the same mul- lead in^.
Eggert (1996). Second, NPV does not
Introduction

~~

~-~

This page of SME-AIME 'bansactions follows page 76. The intervening


non-'bansactions pages appeared in MINING ENGINEERING.

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OCTOBER 1998

69

FIGURE 1

on NPV maximization will lead to the proper results?


The simple answer is yes. However, it is quite possible for
an investor to obtain more insight about an investment
opportunity by using rate of return rather than NPV. For
example, consider Fig. 1,which shows the rate of growth
of a tree or forest and two cyclical harvest schemes.Trees
typically experience low but increasing growth rates
when they are small, then an increasing growth rate for
a period, decreasing growth rates until they reach maturity and negative growth rates thereafter. The classic
forester's problem is when to harvest the trees.
Samuelson (1976) and other economists discuss this
problem.
The correct answer is to cut in a manner that maximizes NPV, but the actions the forester should take using
this criterion are not obvious. Cutting the trees when
they achieve maximum growth (achieve maximum NPV
for one cycle) is not the correct strategy. Samuelson
shows that harvesting at the time of maximum growth
results in the greatest accumulation of wealth in the case
of such cyclical investments. The dotted curves in Fig. 1
show this cyclical harvest pattern.This pattern results in
twice as many cycles as harvesting at maximum growth.
Another correct answer is to sell the trees for cutting
when the rate of increase in wealth caused by tree
growth falls below the owner's opportunity cost of capital.
In this case, it is clear that maximizing based on rate
of growth yields the greatest wealth. While the result is
wealth maximization, this example shows that it may be
theoretically correct and preferred to make investment
and operating decisions on the rate of growth of wealth
rather than the amount of wealth.This suggests that both
the rate of return and NPV can be important to an investor.

Forest example showing two cyclic


harvesting schemes.

Value

Harvest at

indicate the return per invested dollar. which may be of


critical interest to an investor. Many investors are interested in the return on investment, and IRR is one of the
most popular investment criteria used by the mining industry to assess investments (Bhappu and Guzman,
1994). Lastly, certain investment and operating decisions
may be easier to make if based on rate of return rather
than simple profit maximization.
Because NPV and I R R are related. either merit
measure yields the same investment ranking if IRR is
correctly calculated. However, one merit measure may
be preferred over the other by an investor, depending
upon the type of project and the goals of the investor.

Is IRR always theoretically preferred?

Apparent ranking conflict

Assuming the maximization of wealth is the goal of


an investor, is it always true that making decisions based

A criticism is that, for mutually exclusive investment

TABLE 1

Ranking of projects with NPV and IRR with unequal investment or project life.
Years:
Case (a): Unequal project life
CFl*
CF2

NPV

IRR

-100
-100

50
65

50
65

50
65

50
0

50
0

80.24
56.12

41.04
42.57

-100
-50

50
35

50
35

50
35

50
35

50
35

80.24
76.17

41.04
64.12

Calculation of CFZ*
CF2
CFr
CF2"
Case (b): Unequal initial investment
CFl*
CF2
Calculation of CF2'
CF2
CFa
CF2"
Notes:
CFr = reinvested cash flow.
CFa = cash flow from alternative (opportunity) investment.
CFl* and CF2* = the t w o cash flows used to compare NPVs and IRRs.
MARR = Minimum acceptable rate of return = OCC = Opportunity cost of capital = 12.00%.
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OCTOBER 1998

MINING ENGINEERING

opportunities, I R R may give different rankings than


NPV.Table 1 gives an example of the ranking characteristics of NPV and IRR for two cases involving two cash
flows with unequal project lives and unequal initial investments. A third case, not shown, is one of unequal
project lives and unequal investment.
In all cases, a comparison of CFl* and CF2 shows
that C F l * has the higher NPV but the lower IRR. All
cash flows are discounted at the same minimum acceptable rate of return (MARR), which equals the opportunity cost of capital (OCC).
The difficulty here is that it is possible to select a
project with the highest NPV but with the lowest return
o n investment. The problem faced by the decisionmaker, as it is usually stated, is which ranking "system"
should be used? The answer given by engineering texts is
that either criterion can be used, but a mathematical process termed incremental analysis is required to calculate
an NPV-consistent IRR. Examples of this are given in
Au and Au (1988), Newnan (1988), Steiner (1992), and
Stermole and Stermole (1993). The incremental IRR is
determined by using a step-wise pairing comparison of
the rates of return and results in the creation of an index
that ranks projects in the same order as does NPV
The ranking problem illustrated in Table 1 is caused
by violations of two of the five theoretical requirements
when using NPV and IRR as merit measures. These requirements are that:
all projects to be compared must have equal equivalent economic lives,
all projects to be compared must have equal initial
investments,
all values must be known with certainty,
all projects to be compared must have comparable
discount rates that reflect the risk-free opportunity
cost of capital and
all projects to be compared must have comparable
tax structures.
In practice, few projects to be compared have equal
economic lives. A correct ranking can be made of
projects having unequal lives using NPV. However, a correct ranking cannot be made using IRR unless the IRR
is calculated correctly. As shown in Case (a) in Table 1,
what must be compared are the total cash flows that result from the two investments over the same length of
time. Although CF2 ends in Year 3, an account must be
made for income that would be received in Years 4 and
5 as a result of investing in CF2. For example, if the $65
obtained in Year 3 is reinvested at the OCC for an additional two years. CF2* is obtained, which can then be
correctly compared with CFl*. The relevant IRR is the
rate of return over the five-year period. In this case, the
IRR for CFl* is greater than the IRR for CF2*, which is
the same ranking as obtained using NPV. Note that it
might be possible to reinvest in a third project for the
two-year period with different cash flows and a different
OCC. What is important is that the reinvestment in the
two-year period be included in the two cash flow comparisons, whatever the reinvestment opportunities may
be.
Concerning the second requirement, few projects to
be compared have equal initial investments. A correct
ranking can be made of projects with unequal initial in-

vestments using NPV but not IRR, unless IRR is calculated correctly. What must be compared again are the
total cash flows that result from the two investments
over the same length of time. If $100 is available for investment and only $50 is placed into CF2, then an account must be made of the earnings of the remaining $50
not invested in CF2.The combined cash flow of CF2 plus
the alternative investment yields CF2*, which is the cash
flow that must be compared with CFl*. Again, what is
important is that the investment of the unspent $50 be
included in the two cash-flow comparisons, regardless of
how the $50 is invested.
The result of having both unequal project lives and
unequal initial investments combines Cases (a) and (b),
and the same principles apply. Again, what is important
is that the investment of the unspent capital and the reinvestment in the remaining two years be included in the
two cash flow comparisons, however these two items are
invested.
The three additional requirements mentioned above
are discussed in Torries (1998).The solution to the ranking problems associated with unequal project lives and
initial investments is to simply comply with the theoretical requirements of NPV and IRR. If the comparisons of
cash flows are handled properly, no conflicts exist, and an
incremental I R R need not be calculated. There is no
theoretical reason not to use I R R as a measure of
project feasibility.

Multiple root problems


A problem associated with I R R involves the possible existence of multiple roots, which means that there
may be more than one IRR for a single cash flow. IRR is
criticized as a merit measure because the existence of
multiple roots prevents the identification of the unique
I R R to be used to rank the project in question. Some
engineering economics textbooks suggest that NPV is a
superior measure to IRR because multiple solutions are
associated only with IRR. This suggestion is misguided.
Multiple IRRs may occur with projects in which
large capital expenditures are required in both initial
and later years. Under these conditions, the cash flow
patterns may first be negative (corresponding to the initial investment), then positive, then again negative (corresponding to the second investment) and then again
positive. In such a situation there are three specific discount rates at which NPV equals zero and, as a result,
three IRRs.
It is true that there will be only one NPV for any
MARR when there are multiple roots of IRR. However,
the selection of the MARR loses much of its meaning
when there are multiple roots of IRR. Remembering
that MARR is the minimum acceptable rate of return.
what does it mean when a higher NPV is obtained when
the discount rate is higher than the MARR? Using the
higher discount rate, which is supposed to be more constraining than a lower discount rate, results in a higher
NPV. Is it correct to make an investment decision based
on the NPV using MARR when a higher discount rate
gives a higher NPV?
All that can be determined in this case is that multiple IRRs exist and that some discount rates higher than
MARR give higher NPVs. These characteristics of the
cash flow are important to an investor. It would be incorrect to ignore the increase in NPV as the discount rate
MINING ENGINEERING H OCTOBER 1998

71

increases when multiple IRRs exist. Having a cash flow


with multiple IRRs causes problems in interpreting both
NPV and IRR. Therefore, NPV does not have an advantage over IRR because of the multiple root problem.
Because multiple roots affect both I R R and NPV,
they also affect all IRR and NPV derivatives such as the
net future value (NFV), which is directly related to NPV,
and all benefit-to-cost ratios as well as other rates of return, which are all related to IRR. All suffer the same
problems when multiple roots exist.

IRR reinvestment controversy


Another reason NPV is favored over IRR is that the
determination of IRR involves the implicit assumption
that cash-flow dividends are reinvested at the IRR rate.
The argument is that, if I R R requires the reinvestment of
dividends at the IRR rate, the reinvestment rate may be
so high as to be unrealistic. Obviously, reinvestment opportunities at very high rates do not usually exist, which
seems to make the absolute value of I R R inconsistent
when compared to the rates of return on invested capital
from alternative investment opportunities. A reinvestment assumption is also implicit in the determination of
NPV, but the reinvestment rate is equal to the opportunity cost of capital. which. by definition, is an attainable
alternative rate of return. For these reasons. it is argued,
NPV is preferred over IRR.
There is considerable argument in the literature regarding the IRR reinvestment assumption, but it can be
safely said that implicit reinvestment at the IRR rate is
required but that this assumption does not distract from
the usefulness of IRR. The I R R of a project is deter-

mined directly by its own cash-flow profile and is independent of any explicit reinvestment activities or rates.
Consequently, IRR is a measure of growth of capital that
has the same characteristics as quoted savings rates. This
means it is correct to directly compare the two and to say
that a project with an I R R of 40% yields a return four
times greater than a savings account with an interest rate
of 10%.The reinvestment assumption required of IRR is
not a valid reason to prefer NPV as a merit measure. For
a history of the debate, see Solomon (1956). Renshaw
(1957), Dudly (1972). Grant (1982), Lohmann (1988) and
Beaves (1 988).

Inherent stren ths and weaknesses


of NPV and IR

The use of NPV and I R R as merit measures by


which to evaluate the feasibility of a project is well accepted by industry. In a recent survey of mining companies. Bhappu and Guzman (1994) found that 55% of the
companies used IRR and 40% of the companies used
NPV as merit measures.These ratios are only slightly different from two prior surveys of oil and gas producers, in
which one survey found 69% used I R R and 37% used
NPV (Boyle and Schenck, 1985), and the other survey
found 75% used I R R and 62% used NPV (Dougherty
and Sakar, 1993). IRR has been clearly the predominant
merit measure used by the mining industry, although this
position appears to be weakening. It appears that more
companies are using both IRR and NPV as merit measures. which is more logical since each measures a different aspect of value of a cash flow.
Although IRR has been a popular merit measure, its

TABLE 2

Summary comparison of IRR and NPV as merit measures.


NPV
1. Measures the stock of wealth, which is consistent
with economic theory, e.g., maximization of utility or
IVPV. However, NPV does not tell how efficiently
capital is used.
2. The size of NPV is dependent on the rate of return
as well as on the size of the initial investment. NPV
can be made larger by increasing the size of the
project.

IRR
1. Measures the rate of wealth accumulation or the
rate of change of wealth. This measure indicates the
efficiency of use of capital investments. However, IRR
does not indicate the value of a project.
2. IRR is independent of the size of the initial
investment. To make IRR larger, the investment must
earn a higher return

3. Requires price and cost forecasts.

3. Requires price and cost forecasts.

4. Requires the choice of an external discount rate.


Because choosing the proper discount rate is difficult,
this requirement is often cited as a weakness of NPV
that is not shared by IRR. This is not true when
multiple lRRs exist.

4. It is commonly claimed that a discount rate is not


needed, except for a MARR for comparison. This is
true only when there are no multiple roots for IRR.
When multiple lRRs exist, a specific discount rate must
be chosen for comparison, just as in the case of NPV.

5. Assumes reinvestment at the MARR.

5. Assumes reinvestment at the IRR

6. It is commonly claimed that NPV is a unique value


that does not have the multiple root problem that may
exist with IRR. However, if multiple IRRs exist,
multiple discount rates and multiple NPVs must also
be examined.

6. Multiple lRRs may exist and, if so, may complicate


the analysis. This is often incorrectly cited as a
weakness of IRR that is not shared by NPV.

7. hlPV correctly ranks mutually exclusive projects or


investment under conditions of budgetary constraints.

7. IRR correctly ranks mutually exclusive projects or


investment under conditions of budgetary constraints
if IRR is correctly determined.

8. Omits the option value of production and


investment flexibility.

8. Omits the option value of production and


investment flexibility.

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OCTOBER 1998 W MINING ENGINEERING

meaning, problems and relationships with NPV have


been largely misunderstood. To help clarify the differences between NPV and IRR, a summary of a comparison of various characteristics of NPV and IRR is given in
Table 2. For further discussion of these topics, see Torries
(1998).

Conclusion
This paper demonstrates that both NPV and IRR
have valid uses as merit measures for practical application of investment evaluation methods. Because of the
multigoal nature of most investors, the differences in
perspective given by NPV and IRR should be considered a benefit rather than a fault to be corrected. This
paper also shows that IRR has no greater number of
faults than does NPV, even when multiple root problems
are included.
In addition to IRR and NPV, all other bits of information, such as expectations about the future and the
timing of the investment, must also be considered by the
decision-maker. Each investor has a particular set of investment goals and constraints. It is prudent to supply
the investor with as much information as possible and let
the individual investor use the information in a manner
appropriate for the situation. Each investor must then
integrate all project-feasibility information with the
investor's attitude toward risk to reach correct investment decisions.

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