Consistent IRR and NPV rankings

Abstract

Purpose – It is well known that internal rate of return (IRR) and net present value (NPV) rankings of mutually exclusive investments are sometimes inconsistent. This inconsistency, when it occurs, requires decision makers to choose between the two ranking methods. The purpose of this paper is to deduce sufficient conditions for consistent IRR and NPV investment rankings of mutually exclusive investments. Design/methodology/approach – Deductive reasoning is used to obtain the sufficient conditions required for consistent rankings of mutually exclusive investments. Findings – There are different sufficient conditions (methods) that can be used to resolve inconsistent IRR and NPV rankings. However, the different methods do not necessarily produce the same consistent rankings. In particular, different size adjustment methods and reinvestment rate assumptions can produce different IRR and NPV consistent rankings. This paper suggests the appropriate criteria for selecting a particular method for ranking mutually exclusive investments. Research limitations/implications – Like all deduced models, the results apply only to the set of assumptions and preconditions adopted in the model. Furthermore, the application is to ranking mutually exclusive investments. Practical implications – There is probably no other issue in the capital budgeting literature that has generated more attention and debate than the consistency (or lack thereof) between IRR and NPV rankings. This paper summarizes conditions that can be followed to resolve the conflict which should have near universal interest to those working in the capital budging area. This paper offers alternative methods for obtaining consistent IRR and NPV rankings which can be used to improve investment ranking decisions. The particular method used should depend on the decision environment. Guides for choosing the appropriate ranking method are described in the paper. Social implications – Significant decisions, projects, and investments are evaluated using either IRR or NPV methods. This paper shows that existing evaluation methods can lead to sub-optimal investment choices and provides an improved framework that facilitates better investment choices. Lacking an understanding of the sufficient conditions for IRR and NPV consistency – means that resource allocations have been made to investments and projects that are not optimal. Originality/value – To the best of the authors’ knowledge, the results are this paper have not been published nor are they available elsewhere. That said, this paper builds on important earlier work which is carefully cited and credited.