The ranking of project differs, depending on the use of IRR or NPV measures. Which project should be selected? Why is the IRR ranking misleading?
To compare and rank different investment projects, commonly used measures are the Internal Rate of Return (IRR) and Net Present Value (NPV).
IRR is the rate at which the net present value of cash flows equals zero. It represents the discount rate at which the project's inflows and outflows break even. When ranking projects based on IRR, the higher the IRR, the more attractive the project is considered.
On the other hand, NPV calculates the present value of cash inflows and outflows by discounting them at a chosen rate of return. It measures the profitability of a project by determining the net value it adds to the investor's wealth. For ranking projects based on NPV, the higher the NPV, the more desirable the project is considered.
Now, to answer your question, the project selection may differ depending on whether you use IRR or NPV measures. In general, if two projects have different rankings using IRR and NPV, it is recommended to rely on NPV as the primary criterion for project selection. Here's why:
IRR ranking can be misleading because it assumes that cash flows generated from projects will be reinvested at the project's IRR. However, in reality, reinvesting at the IRR may not be achievable or may not provide the highest return. Therefore, the IRR ranking assumes a reinvestment rate that might not be realistic.
Another potential issue with IRR ranking is when projects have non-conventional cash flows, i.e., cash flow patterns with multiple changes in directions (negative to positive or vice versa). In such cases, calculating a single IRR becomes challenging, and IRR rankings might not accurately reflect the relative profitability of projects.
In contrast, NPV overcomes these shortcomings by explicitly considering the discount rate chosen for cash flow valuation. It assumes that cash flows are reinvested at a rate that is reflective of the investor's required rate of return or the cost of capital. NPV allows for a consistent comparison of projects, considering their cash flows and the investor's expectations.
To summarize, the project selected should be based on the NPV ranking rather than the IRR ranking. NPV provides a more reliable measure of profitability, considering the investor's required rate of return and the actual reinvestment opportunities for cash flows.