MODULE ON INVESTMENT SELECTION Article #4 INVESTMENT SELECTION BASED ON RETURNS

In a previous article (How to Know if an Investment is Better or Worse than Another?) I explained that the present value PV represents the sum you need to invest to get a certain amount at the end of a year, given a certain discount rate. The discount rate being the minimum return that is required for the investment according to its risk.

For example, €100 is the PV of €112 for a discount rate of 12% per year, because €100 is the amount you must invest to get €112 if the required return is 12%.

I also showed that net present value (NPV) results from subtracting the initial investment from the present value corresponding to the amount of money received in a year. If in the above example the amount initially invested was €90, the NPV would be €10 (€100 minus €90).

It was concluded that the NPV method was useful for deciding whether an investment was acceptable, and also to compare it with other investments involving different amounts and risks.

The procedure discussed in this article is an alternative to NPV that is also used to make investment decisions. It consists in calculating the return which corresponds to a NPV of zero. This return is called the "internal rate of return" (IRR). Then, this return is compared to the discount rate that would be required for investments of the same risk. If the IRR is greater than the required discount rate, the investment is acceptable because its return is superior to the minimum required. Otherwise, the investment should be rejected.

Continuing with our example, if we write the formula for its NPV:

NPV = -90 + 112/(1+r)

The IRR is calculated by solving the following equation:

0 = -90 + 112/(1+IRR) 

The result is 24.4%. Since this yield is higher than the discount rate of 12%, the investment should be accepted.

If the initial investment is now €110, the equation to be solved becomes,

0 = -110 + 112/(1+IRR)

And the IRR would be 1.8%. As this return is less than 12%, in this case the investment must be rejected.

The main advantage of the IRR is that it is easy to understand. Anyone grasps the meaning of the return on an investment, and that if this return is above the minimum required it must be accepted, or rejected otherwise. Moreover, the meaning of NPV is much murkier. How should we interpret that a NPV is +€8.6, or -€7.4? Is it too much? Is it too little? This is why the IRR has always been more popular than the NPV among investors.

However, the NPV rule never fails while IRR has two problems. The first is that its calculation is difficult when analyzing investments that extend for more than two years. Fortunately, since computers have been available this has ceased to represent a difficulty.

The second, and much more important, problem is that the IRR can lead to wrong decisions when comparing investments whose invested amounts differ, or where additional disbursements must be made beyond the initial moment.

That is why scholars have been fighting for years to propagate the NPV method among analysts. However, while the NPV method is increasingly used, IRR remains very popular.

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