THE IRR RULE IS REDUNDANT AS AN INVESTMENT CRITERION BECAUSE THE NPV RULE ALWAYS DOMINATES IT
IRR & NPV
Net Present Value (NPV) is a measure used to determine whether a project is worth investing in. The NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows to the present value, using the required rate of return (RRR).
NPV compares the amount that has been invested today with the present value of the expected future returns. In other words, NPV compares the amount invested today with the future returns after it has been discounted by required rate of return (RRR). The RRR can also be called as the discount rate, hurdle rate or the opportunity cost of capital.
NPV takes into account the principle in economics referred to as the “time value of money” which implies that a dollar earned today is more valuable than a dollar earned tomorrow. It is to be noted that projects with zero or positive NPV are acceptable to a company from a financial viewpoint as the return from these projects equals or exceeds the cost of capital.
Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. IRR represents the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows.
Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.
It is to be noted that NPV uses an absolute amount IRR is interpreted in terms of ‘Rate’. The IRR calculation assumes that the cash flow from the project can be reinvested at the Internal Rate of Return, while the NPV doesn’t consider any such assumptions....