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Capital Budgeting: NPV v.

IRR Controversy
Unmasking Common Assertions

by Jan F. Jacobs

Ir Jan Franciscus Jacobs (BK T.H. Twente 1974), The Netherlands


This paper can be downloaded from the

Social Science Research Network Electronic Paper Collection:
Abstract Jan F. Jacobs

Capital Budgeting: NPV v. IRR Controversy

Unmasking Common Assertions


The conflict1 between NPV and IRR arises because of misinterpretations that
have been made. There is no real conflict. The solution of a polynomial is the
subject matter: no more, no less. The NPV-method and the IRR-method are
not two measures of investment worth - as it is reported in many textbooks -
but just one single method. Moreover, the NPV/IRR-method is plain mathe-
matics and does not pretend to be a ranking device; it cannot be used as such
either. Mathematics is yes indeed a tool, but economics can only then be the
master if the tool is used properly and the results are interpreted correctly.
To help assess the very basics of reckoning investment opportunities as
well as to improve the current pedagogy - the latter is so dearly necessary - are
the two reasons for writing and publishing this paper.

Mentioned e.g. on page 106 by Keef and Roush (2001); paper on the topic fallacy of the
reinvestment assumption, mentioned in many management accounting and finance texts dis-
cussing the NPV v. IRR conflict. 1
Introduction Jan F. Jacobs


Capital budgeting decisions are among the most important choices made by
managers; selection or rejection of investment proposals defines the firm's
profitability and, in the end, its survival. Words of similar purport have been
written down by Keef and Roush (2001) and many other writers. Educators, in
the context of capital budgeting, and the textbooks they utilize, should convey
correct information, however conceptual errors are broadcast far and wide.

"The common assertion that the NPV v. IRR controversy hinges on the
rate of reinvestment … is … based on a misunderstanding …. Conflict
between IRR and NPV can be attributed entirely to the effects of scale
… (Keane, 1979, 55)."

"Mathematics is a tool … economics [is] the master … [the] problem

arises from confusion of this hierarchy - from trying to make economics
conform to the mathematics (Herbst, 1982, 92)."

An example, given by Jacobs (1996), see fig. 1.

fig. 1 cash flows

C0 = -/- 300 money units

C1 = + 110 money units
C2 = + 121 money units
C3 = + 133.10 money units 2
Introduction Jan F. Jacobs

= the discount rate 'per' period (discrete), for each of the three periods.

It is easy to calculate: the Net Present Value (NPV), the balance of the present
values of all cash flows, at different values of I.

NPV is a function of I. In general: y = f(x), a curve in the flat plane, see fig. 2.

0 64.10
2 49.57
4 35.97
6 23.22
8 11.25
10 0.00
12 -/- 10.59
14 -/- 20.56
16 -/- 29.98
18 -/- 38.87
20 -/- 47.28

fig. 2 NPV = f(I)

The curve in this example does not raise any problems; there is only one value
of the discount rate for which NPV is equal to zero. This value, 10 %, is the
above mentioned IRR. 3
Introduction Jan F. Jacobs

Our example, see table 1.

Point in time Receipts Expenses Cash surplus

0 300 -/- 300
1 110 110
2 121 121
3 133.10 133.10
Total revenue 64.10

table 1 receipts and expenses ending up in total revenue 4
Discussion Jan F. Jacobs


Total revenue being 64.10 can never be changed without changing the data. It
is a fact. All that can be done is to present this fact in a reasonable way. And
next that outcome has to be judged. Of course a correct judgement is only pos-
sible if and when both the outcome and the demand have been formulated in
mutually comparable terms. If financing is taken care of with money bearing
an interest rate of (discrete) 7 % a year (period), then the judgement in our
example reads:

 NPV at a discount rate of 7 % is positive i.e. 17.14

 IRR is higher than 7 % i.e. 10 %

and both findings lead to the same conditional conclusion: regarding data and
model, the investment proposal is acceptable until further notice.

There has been (in some textbooks there still is) discussion about which one of
both findings has the first claim. The discussion is irrelevant because insight in
the polynomial is essential and that insight leads to both findings simultane-

To get the IRR figure(s) is not always that simple as is shown here, but it is
easy to verify, see table 2.

Year (period) Invested capital IRR Invested capital

at the beginning 10 % at the end
1 300 30 330
2 220 22 242
3 121 12.10 133.10
4 0 --------

table 2 IRR meets total revenue

In practice, one generally cannot do much with the above-mentioned condi-

tional conclusion. A strategic investment proposal must normally be under-
pinned more thoroughly. The literature offers numerous starting-points to do
so. One can make calculations as far as one likes to go. To indicate some re-
finements: sensitivity analysis, risk, taxes and time schedule. One can almost
go on forever in making refinements. The resulting deeper understanding is
the ultimate goal. One may expect everything, for instance polynomials with-
out an IRR figure or more IRR figures. The most realistic calculation will be
somewhere in between the most optimistic and the most pessimistic scenario. 5
Discussion Jan F. Jacobs

Next each and every investment must be compared with at least one other in-
vestment. To do something by implication means that it is no longer possible
to do something else. In comparing two investments mutually one has to deal
amongst other things with the sizes of the investment proposals. Suppose, to
put it clearly, investment A the size of one euro is promising a sky-high IRR
of for instance 1,000 % while the alternative investment B the size of one mil-
lion euro generates a relatively low IRR of 40 %. The given cut-off rate in
both cases is 12 %. Of course one prefers investment B with the low IRR-rate.
Knowing only IRR-rates simply is not enough in order to make a sound
choice. The same holds true for knowing just a few NPV-values. It is impor-
tant to see the graph(s) of the polynomial(s) and not just a few points.

NPV and IRR are not two measures of investment worth, they are just two
sides of one and the same method. NPV is a function of the discount rate. In
general: y = f(x), a curve in the flat plane. Both findings NPV and IRR follow
from the very same mathematics.

“..... it is vitally important that the user understands what it is he is accom-

plishing by discounting the cash flow of an investment, and what he is not ac-
complishing. Unfortunately some of those who have advocated use of this pro-
cedure have done so for the wrong reasons or have made claims for it that
cannot be fulfilled. All of us recognize that the simple screwdriver is a useful
tool when properly used. There is no need to revise that opinion because an
inexperienced do-it-yourself enthusiast reports disastrous consequences from
his attempt to use a screwdriver in a situation where a chisel was required
(Bierman/Smidt, 1966, 62/63).”

The common reinvestment assumption happens to be no more than a side-

issue (and it is bare nonsense), whereas the essentials are misunderstood
broadly or have been not even seen. The crux of the matter is: by way of the
NPV/IRR-method, one can assess the conditional acceptability of one invest-
ment proposal solely, and mathematics does not pretend that it states anything
meaningful with regard to the order of two (or more) investment proposals.
Various writers have done so for the wrong reasons and have made claims that
cannot be fulfilled.2

Of course the IRR-rates concern the invested capital, precisely the amount and
the course in time. Real rates never implicate the money that has already been
refunded. One should regard the size, the changing size of each investment,
explicitly. Apart from that, the availability of capital will never be exactly the
same for different investments in practice. Mostly these investments have dif-
ferent life cycles too. Capital budgeting decisions are often very difficult.

"The express purpose of these cognate methods, in the context of two mutually exclusive
projects, is to select the investment that will maximize the wealth of shareholders. It is gener-
ally well recognized that the NPV method and the IRR method can lead to conflicting signals
(Keef and Roush, 2001, p. 106)." 6
Discussion Jan F. Jacobs

IRR measures the earning power of an investment. It is the presentation in

usually one number of the total gain of an investment. Not the number nor the
gain but the real profit is what matters. The mentioned polynomial does not
measure the real profit i.e. not necessarily identical to the gain nor does it say
anything about when to collect the gain. That can be done at the end, during
the life cycle, or even at the very beginning. It must be remembered, it is just a
limited polynomial.

According to many in the field, the best method (at least a good one) to evalu-
ate investment proposals is the present value method or (a variant) the method
of the internal rate of return. It is indeed by far a better measure of investment
worth than a lot of really bad methods, but nevertheless it does not have a gen-
eral validity. An investment often implies at least one (possible) re-investment.
Think of calamities and commitments to deliver. There can be the duty to re-
place even in the case of a one-off investment. If so then the real total profit is
not identical to the receipts minus the (initial) cash outlays. Only NVD has
been covered. Apart from NVD and SVD - these notions are mentioned in
several papers e.g. Profit Measurement - New Principle (Jacobs, 2004)3 - still
it holds: normal depreciation is included, but the whole area of possible price
increases, necessary re-investments, and backlog depreciation, is disregarded
by the present value method.

Profit Measurement - New Principle 7
Conclusion Jan F. Jacobs


The (nominal) NPV/IRR-method (including the models that are based on it,
for instance the CVA® concept)4 neglects substantialism. The present value
method c.q. the method of the internal rate of return (not two measures of in-
vestment worth as it is reported in many textbooks but just one single method)
fails in numerous cases in making sound capital budgeting decisions. This is
because of the fact that the NPV/IRR-method meets only nominalism. It is
providing for NVD, and maybe for SVDgeneral as well, for instance by using an
alternative rate, but it does not contain SVDspecific (Jacobs, 2003).5

Ottosson and Weissenrieder (1996) and Weissenrieder (1997).
The classical NPV/IRR-method meets only nominalism. A real good method contains every-
thing. Paper Neither EVA® nor CVA® but NVA, introduces a
modern NPV/IRR-method including SVD. 8
References Jan F. Jacobs


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Analysis and Financing of Investment Projects -, Collier MacMillan Interna-
tional Editions, New York/London, 1971.
Brealey, R.A. and S.C. Myers, Principles of Corporate Finance, 6th edition,
Boston, Massachusetts: Irwin, Mc Graw-Hill, 2000.
Bulte, J., J. Dijksma and R. van der Wal, Management accounting, Wolters-
Noordhoff, Groningen, 1995.
Dudley, C.L., A note on reinvestment assumptions in choosing between net
present value and internal rate of return, Journal of Finance, 27 (4), pp. 907-
915, 1972.
Hartley, R.V., Teaching capital budgeting with variable reinvestment rates,
Issues in Accounting Education, 6 (2), pp. 268-280, 1990.
Herbst, A.F., Capital Budgeting: Theory, Quantitative Methods, and Applica-
tions, New York, NY: Harper & Row Publishers, 1982.
Jacobs, J.F., Bedrijfseconomie voor iedereen, JBA-Databank, Enschede, 1996.
Jacobs, J.F., Profit Calculus: Undertaking profit calculus is simple, the
method is easy to learn and to put into practice, Shaker Verlag, Aachen, 2016.
Jacobs, J.F., Neither EVA® nor CVA®, but NVA
Jacobs, J.F., Like EVA®, the CVA® Concept Cannot Stand the Test Either
Jacobs, J.F., The Quest for Value Revisited
Keef, S.P. and M.L. Roush, Discounted cash flow methods and the fallacious
reinvestment assumption: a review of recent texts, Accounting Education, 10
(1), pp. 105-116, 2001.
Keane, S.M., The internal rate of return and the reinvestment fallacy, Abacus,
15 (1), pp. 48-55, 1979.
Kendall, M., Multivariate analysis, Charles Griffin & Co., London, 1975.
Most, K.S., Accounting Theory, Grid Inc., Columbus, Ohio, 1977.
Weissenrieder, F. and E. Ottosson, CVA, Cash Value Added - a new method
for measuring financial performance, Gothenburg Studies in Financial Eco-
nomics, Study No 1996:1, re SSRN_ID58436. 9
References Jan F. Jacobs

Weissenrieder, F., Value Based Management - Economic Value Added or

Cash Value Added, Gothenburg Studies in Financial Economics, Study No
1997:3, re SSRN_ID156288. 10