IRR vs NPV

One of the problems with NPV is that we need to know the cost of capital, but in practice it is impossible to know the cost of capital with certainty.

So….we might think that the cost of capital is 10% and at 10% the NPV might be positive, but what if the cost of capital is 11% or 12% etc.? With higher cost of capital the NPV will be lower. As long as the NPV is still positive then we are still OK to go ahead with the project, but if it turned out to be negative then we would have made the wrong decision.

The beauty of the IRR is that it gives a margin for error. If the IRR is (say) 12% then it means that the NPV will be positive (and therefore we should do the project) provided that the cost of capital is less than 12%. The more likely it is that the cost of capital might be more than 12% then the more risk we are taking if we do the project.

The other reason people use it, is that it is easier to explain the non-accountants that if the cost of capital is 10% and the IRR is 12%, then we should do the project. They understand that, but they might not understand “we should accept the project because the NPV is positive at 10%”. You should mention that in the exam, but it is a bit of a cheat because the IRR is not really a rate of return – it is the rate of interest at which the NPV is zero!

I hope that makes sense 🙂

PS In the exam, we use NPV and only calculate the IRR if the question asks you to calculate it.