NPV vs IRR vs Payback Rule

This is originally posted on Sunday, 3 February 2013 at 16:06

2011 ZA,ZB 3c

Explain why the NPV is a better investment appraisal technique than the IRR 

2010 ZA 3b 

Compare the advantages and disadvantages of the NPV and IRR.

When appraising multiple projects, their NPVs can be directly added together to obtain the Multiple Project NPV. The Multiple Project IRR, on the other hand, requires that total cashflows of multiple projects to be re-computed for each period. 

The IRR, being the solution to a kth order polynomial in r, may have take on multiple values. This makes IRR appraisal ambiguous as there is no instruction to select a specific IRR value for comparison against the hurdle rate. This situation is more pronounced if cashflows are unconventional- the number of IRRs generated depends on changes in the direction of cashflow.  Selection by NPV is more clear-cut because it accomodates both conventional and unconventional cashflows- ambiguity by NPV rule only arises when projects have identical NPVs. 

The cost of capital varies across time, but the IRR approach assumes that spare cashflows can always be reinvested at the same IRR- an unrealistic assumption. This is a stark contrast to the NPV approach which has the flexibility to incorporate different cost of capital across time in its computation.   

Unlike NPV, the IRR of a project does not account for the size and magnitude of the projects. A project with higher IRR may be chosen over another, but its actual NPV may turn out to be lower when reference is made at the hurdle rate. 

However it is noteworthy that IRR has a distinct advantage over the NPV:  while NPV calculates  absolute values, IRR is a relative measure of value. Therefore the IRR can act as a form of efficiency measure while NPV fails to do so. However, it is possible to complement NPV with other techniques of efficiency measures such as the profitability index and annual equivalent value.  

2010 ZB 3b 

Explain why NPV is a more preferable technique for capital budgeting than other methods.

2007 ZA 5c, ZB 6a 

Describe the NPV rule, the IRR criterion and the Payback rule for investment. What are the relative advantages and disadvantages of these rules?

Write the above, but need to include two short paragraphs on the Payback Rule. The Multiples Method is NOT a capital budgeting method. Its main purpose is to assess value (ie. value of firm) rather than project selection (capital budgeting decision). 

The Payback Rule is flawed because it neglects the cashflows after the payback period. Unlike the NPV, the payback rule provides an inaccurate picture of the overall returns from the project. Even if the Payback rule is fulfilled (cashflows cover capital outlays by the payback period), future gains and losses (positive and negative cashflows) after the payback period are not incorporated into the analysis. This issue is not resolved even when cashflows are discounted, and the Discounted Payback Rule is used.  

However Payback Rule may be used in conjunction with NPV to assist in better decision making. This is because certain projects may have positive NPVs, but the bulk of the positive cashflows only arrive after the payback period. The firm may face a short period of liquidity crunch (up to the payback period) following an investment in the positive NPV project. Therefore the Payback Rule can be used to preempt such contingencies.