Choosing Between NPV
and IRR in Investment Project Appraisal
It is clear that applying both Net Present Value (NPV) and Internal Rate
of Return (IRR) methods in appraising the financial efficiency of a project is
essential. However, the issue lies in determining which metric is more reliable
for evaluating a project's financial performance. NPV provides an absolute
value (similar to total profit), while IRR provides a relative value (similar
to profit margin). Mathematically, when the discount rate used to calculate NPV
equals the IRR, the NPV is zero. Therefore, the NPV value depends heavily on
the applied discount rate; if this rate is chosen subjectively, the NPV results
will become unreliable.
Key Considerations When Calculating NPV and IRR: The application of the discount rate
(r) to calculate NPV is usually based on the bank interest rate plus a
risk premium. It is this risk premium that makes the rate r differ
across projects; the higher the r, the lower the NPV, and vice versa.
However, r cannot be lower than the bank deposit interest rate at the
time of calculation, as this represents the lowest opportunity cost of capital.
Regarding the risk premium, it can be applied in the following scenarios:
- Setting r equal to the
bank rate: If calculating both NPV and IRR, we can set r equal to the
bank deposit interest rate to calculate NPV. This is because investors can
look at the IRR to measure the investment's attractiveness relative to its
risk, while NPV represents the incremental value after capital recovery,
discounted at the current opportunity cost without adding a risk factor.
The advantage of this approach is that NPV is always calculated
objectively since r is strictly pegged to the bank deposit rate.
- Including a risk premium: In cases where it is necessary
to include a risk premium in r to increase the reliability of the
NPV, r will be higher than the bank interest rate. However, it
should not be excessively high; for example, if the bank interest rate is
10%, r should not exceed 15%. The exact value of r should
rely on the estimator's experience at that specific time. Some principles
for determining r include:
- Economic outlook and inflation: If inflation is predicted to
rise, r should be increased, and vice versa.
- Capital recovery rate: If the capital recovery rate of
the invested assets is high, r will be low, and vice versa. Under
this concept, investments in the real estate sector will use a lower r
than manufacturing sectors, and investments in new products will have the
highest r due to their significant inherent risk.
Project Selection Based on NPV and IRR: In principle, an effective project is one with an NPV
> 0 or an IRR greater than the bank interest rate. However, depending on the
investor's perspective and purpose, one metric may be prioritized over the
other, especially when there are multiple projects to choose from. Below are
some scenarios for using NPV and IRR to evaluate investment efficiency:
- Abundant capital, limited
projects: If the investor has abundant capital, the investment climate is
challenging, and there is a shortage of viable projects, the project with
the highest NPV will be chosen. The investor lacks alternative options,
and capital availability is not a primary concern.
- High safety projects: If a project is assessed as
highly safe, the highest NPV is the decisive factor. Because of the
project's high safety, the investor will not worry about capital shortages
due to the ease of fund mobilization.
- Efficient capital utilization in
a growing economy: If the investor wants to use their capital most efficiently in a
developing economy with many good projects available, the project with the
higher IRR will be chosen. Investing in a higher IRR project yields better
capital efficiency, assuming the risk factors of the compared projects
have been isolated.
- Limited equity, high risk
tolerance, and abundant credit: If the investor has limited capital but is willing to take risks
for high returns, and credit sources are readily available, the project
with the higher IRR will be selected. By investing in a high-IRR project,
the investor can leverage bank credit to generate substantial profits
relative to their limited equity.
Conclusion: The scenarios above illustrate that there is no single, fixed criterion
for evaluating and selecting investments. Calculating NPV and IRR is not the
difficult part—especially with Excel's financial functions, which make the
computation extremely fast and straightforward. The crucial aspect is how
investors evaluate and decide based on those NPV and IRR figures. Investment
decisions are inherently difficult, involving risk and requiring decisiveness.
Only then does the resulting investment efficiency become a worthy reward for
those who dare to do business and embrace risks.