Why NPV rocks

Net present value (NPV) is the most versatile investment metric. It’s based on forecasted cash flows and the opportunity cost of capital. You should accept any investment projects with NPV greater than zero. NPV is an absolute measure, it recognizes the time value of money, and is less prone to interpretation mistakes than its alternatives. Alternative investment criteria such as profitably index, payback period, and the internal rate of return are missing one or more of these characteristics. Let’s examine them.

The profitability index, also known as benefit-cost ratio, is defined as the present value of future cash flows divided by the initial investment. The profitability index rule is to accept any investment project with an index greater than one. Profitability index most closely resembles net present value. When some people refer to return on investment (ROI) as a metric, they basically mean the profitability index, assuming of course that the ROI calculation is done correctly as described in one of the previous posts.

However, the key problem with the profitability index is that it’s a relative metric. A relative metric doesn’t allow to make reliable comparisons of investment alternatives. A ratio doesn’t tell you in absolute terms how profitable an investment is versus all investment options. It only tells you how profitable it is versus its own investment.

The payback period is determined by the number of periods – usually years – it takes until the cumulative cash flow becomes positive. Investment projects are accepted if the payback period meets some predefined cutoff period. Since this rule doesn’t take the time value of money into account, a slightly better version of this metric is the discounted payback period, which is based on cumulative discounted cash flows.

In either case, the payback period is a subjective measure. It is driven by an arbitrary choice of a cutoff period. This metric ignores any cash flows thereafter. Is an investment with a 2-year payback period better than one with a 3-year payback period? Without analyzing cash flows after these 2 or 3 years, i.e., without knowing the absolute profitability, it’s impossible to tell.

The internal rate of return (IRR) is defined as the discount rate at which an investment project would have zero NPV. According to the IRR rule, you should accept any investment project offering an IRR above the opportunity cost of capital. Although IRR is widely used in finance and is based on discounted cash flows, i.e., it takes time value of money into account, it has several drawbacks.

First, the calculation of IRR is iterative. Although most spreadsheets and financial calculators provide an IRR function, you have to start with a guess for the IRR. Spreadsheets or calculators try then to determine the true IRR through several iterations. This wouldn’t be problematic in itself, but this brings us to the second issue.

Second, if the cash flow changes across periods from positive to negative or vice versa more than once, there may be several IRRs or no IRR at all. The wrong initial guess of the IRR for the iterative calculation will lead to the wrong final IRR.

Finally, as with any relative metric, IRR is unreliable in ranking projects of different scale and risk. Is an investment with an IRR of 19% and the opportunity cost of capital of 12% better or worse than an investment with an IRR of 13% and the opportunity cost of capital of 6%? In both cases IRR is 7 percentage points above the opportunity cost of capital. But without knowing the absolute investment returns it’s impossible to tell which investment is financially sounder.

Although there were more shortcomings of IRR discussed here than of the other two metrics, it doesn’t mean that IRR is worse. However, since IRR is widely used but can be easily misinterpreted, we spent more time addressing its drawbacks. By the way, others agree with us regarding the weaknesses of IRR. The CFO Magazine, for example, published a McKinsey article that warns of using IRR and claims that the most straightforward way to avoid problems with IRR is to avoid it altogether.

To summarize, NPV rocks.

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