NPV, IRR, Payback, and the investment decision

For investments with “traditional” cash flows, it doesn’t make a difference whether we consider
NPV or IRR in order to make the investment decision with regard to a single project. Both will
lead to the same decision. Consider the following cash flows:

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Project A ($10,000) $4,000 $6,000 $8,000 $7,000 $4,000

Of course, the decision whether or not to invest in this project will depend on the discount rate.
With traditional cash flows – a negative cash flow to start the project, and positive cash flows
thereafter – it will always be the case that higher discount rates correspond to lower values. In
fact, you can easily graph this relationship in what is referred to as an NPV Profile:

NPV Profile
$25,000.00

$20,000.00

$15,000.00

$10,000.00

$5,000.00

$0.00
5%
0%

10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%

($5,000.00)

($10,000.00)
The y-axis in this graph is the NPV, while the x-axis shows increasing discount rates. The shaded
area in this graph represents the profitable projects. If the discount rate of this project goes
above 47.59%, the project is not profitable; for any discount rate below that, it is. This is
observable on the graph as this is the point where the NPV profile crosses the x-axis.
Note that the decision rule for either NPV or IRR yields the same decision under any discount
rate for this project. The NPV rule dictates accepting the project when the NPV is positive – the
shaded area in this graph. The IRR rule matches this exactly, as it would imply acceptance as
long as the discount rate is below the IRR. Since the IRR is where the NPV profile crosses the x-
axis, this maps perfectly to the NPV decision.
This is only true because of the shape of this NPV profile. As long as the NPV is positive at a rate
of zero (i.e., the nominal cash flows add to a number greater than zero), and the cash flows are
traditional, this will be true. However, there are other possibilities:

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Project B ($10,000) $10,000 $11,000 $13,000 $10,000 ($37,000)

NPV Profile
$5,000.00

$4,000.00

$3,000.00

$2,000.00

$1,000.00

$0.00
55%

90%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%

60%
65%
70%
75%
80%
85%

95%
100%

($1,000.00)

($2,000.00)

($3,000.00)

($4,000.00)
In this case, there are multiple IRRs. This is always a possibility if there are multiple sign changes
in the cash flows. In this case, the NPV profile crosses the x-axis twice; once at 5%, and again at
82%. The NPV rule still applies; if the discount rate yields a positive NPV, you should accept the
project. That corresponds to the shaded area again. Note that this does not map to the IRR rule,
which now might lead to the wrong decision; the project should be accepted for any discount
rate between the two IRRs. This will not always apply to a project with multiple IRRs, sadly, and
the only way to really be sure is to map the NPV profile as we have done here. Alternatively, the
best approach is to simply use the NPV measure in cases with multiple sign changes in the cash
flows.

Mutually exclusive projects – the crossover rate

That is as far as you need to go in your analysis if you are analyzing one project at a time.
However, you often need to decide between projects. In many introductory classes, this
concept of mutually exclusive projects is introduced with the idea of projects that use the same
resource and thus cannot both be invested in simultaneously. Perhaps two projects both use
the same unique piece of land, for instance.
In the real world, the constraining resource is often capital. Introductory classes consider firms
that are large, public firms with unlimited access to debt and equity capital markets. In practice,
most firms are small and private, and no firm actually behaves as if it has unlimited capacity for
debt and equity. As a result, most firms operate under financial constraints (some much more
so than others). This often means not simply engaging in every NPV-positive project, as there
are more profitable projects than the firm can fund. We are left trying to rank our projects, or
at least express a preference for one over another.
This can lead to problems. Consider the following two projects:

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Project A ($10,000) $4,000 $6,000 $8,000 $7,000 $4,000

Project C ($10,000) $9,000 $5,000 $5,000 $4,000 $1,000

The IRR for project A is about 48%, as discussed earlier. Project B’s IRR is 55%. Choosing
between these two projects based on IRR, you would select project B. However, using NPV
might lead you to a different decision, depending on what the discount rate is:
 NPV Profiles
$25,000.00

$20,000.00

$15,000.00

$10,000.00

$5,000.00

$0.00
0% 20% 40% 60% 80% 100% 120%

($5,000.00)

($10,000.00)

In cases where the discount rate is below 30%, project A is more profitable. At higher discount
rates, C is more profitable. You cannot simply judge the projects based on their relative IRR.
You can find this crossover rate, if it exists, by calculating the IRR of the incremental cash flows
(i.e., subtract all of project A’s cash flows from project C’s, use that as your cash flows and
calculate the IRR).

Mutually exclusive projects – varying investment size or horizon

Notice that in all of these cases, we’ve used projects that have the same initial investment size
and the same investment horizon (the projects cost the same to start and conclude after the
same number of years). Varying either of these parameters can cause problems as well when
comparing projects.
Compare mutually exclusive one-year projects X and Y, knowing only that project X has an IRR
of 80% and project Y has an IRR of 35%. Since you can only invest in one project, you’d be
forced to conclude that project X was a better investment. What if project X had an initial
investment of $100, versus the initial investment of $1,000,000 for project Y? For an NPV of
$80, you would be giving up $350,000. It’s pretty likely this is a poor decision. This is an extreme
example, but it clearly shows why IRR may fail us when considering investments of different
size: IRR, like any return-based measure, does not take scale into account.
At this point, you may be wondering why any analyst would ever stray away from NPV as their
primary decision-making tool for investments. Used properly, it generally is the safest bet.
However, when considering direct project cash flows in isolation, it can lead to the wrong
decision when deciding between two projects with different time horizons.
Another situation: project M has an NPV of $1 million, while project N’s NPV is $800,000. Both
require the same initial investment. While its superior NPV would lead you to select project M,
you might rethink that decision if project M takes 6 years to run, while project N receives all its
cash flows in 3 years. A naïve application of the NPV process would lead you to the wrong
decision here. IRR would have given you the correct decision, although a more common
approach for a situation like this would be EAA (equivalent annual annuity) or EAC (equivalent
annual cost).