Question

1. Critique this statement: “NPV is a better measure of project profitability than IRR because it leads to better capital investment decisions.”
2. From a purely financial perspective, are there situations in which a business would be better off choosing a project with a shorter payback over one that has a larger NPV?

Answer 1

a]

Yes, NPV is a better measure because it measures the actual wealth generated, or value created, for investors. IRR is a percentage measure, and does not measure the value created. Further, IRR cannot be calculated for projects involving negative cash flows in multiple years, and in such cases the there may be multiple IRRs or the IRR may be indeterminable.

Due to these reasons, NPV is a better measure and results in better capital budgeting decisions.

b]

In some cases, the project may have uncertainty regarding cash flows. For example, the project may be in a different country with uncertain political environment, uncertain policies or uncertain tax rates. In such a case, a project with a shorter payback should be chosen so that the expected NPV is higher.