Comparison of NPV and IRR

Both the methods give the same accept-reject decision when a single or independent project is evaluated. The NPV is positive only if the IRR on the project exceeds the marginal cost of capital or risk adjusted discount rate used by the firm. Similarly, the NPV is negative only when the IRR is smaller than the marginal cost of capital. However, in the case of two or more mutually exclusive projects (i.e., when only one of the investments will be made), the two evaluation techniques may provide contradictory Signals as to which project will add more to the value of the firm.

The reason for the inconsistency is that there is a difference in the implied reinvestment rate for the annual cash flows each year. That is, the cash returns from the capital project each year are reinvested, but the rate earned from reinvested rupees is not known. Under the NPV method, the net cash flows generated by the project, are implicitly assumed to be reinvested at the firm's cost of capital (k). While under the IRR method" the net cash flows generated by the project are implicitly assumed to be reinvested at the same higher IRR earned on the project.

The firm should prefer the NPV approach when the two methods provide contradictory signals. That is, the firm should select the project with higher NPV rather than the one with higher IRR. This is so because there is no certainty that the firm can reinvest the net cash flows generated by a project at the same higher IRR earned on the given project. 

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