Question

Explain the difference in project selection using NPV verses IRR.

Which is preferred by managers and by investment entities and why?

Answer 1

Using NPV, a project is selected if the NPV is positive, or has an NPV more than a minimum required NPV. Otherwise, the project is rejected.

Using IRR, a project is accepted if the IRR is higher than a minimum acceptable rate of return, or if the IRR is higher than cost of capital. Otherwise, the project is rejected.

Managers prefer IRR because it provides a single rate of return which can be easily compared to the investor's required return. IRR is preferred by managers because it serves as a risk measure for managers.

However, investment entities prefer NPV. This is because NPV measures the actual value or wealth created (in currency amount) for investors. Also, a project with positive NPV will have funds available for distribution to investors.