Key difference between most popular methods of project evaluation (NPV vs.

IRR):
NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not. The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm). However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital. While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.

There are three main reasons why NPV is usually the best choice for measuring project value.
NPV assumes that project cash flows are reinvested at the company's required rate of return; the IRR assumes that they are reinvested at the IRR. Since IRR is higher than the required rate of return, in order for the IRR to be accurate, the company would have to keep finding projects that would reinvest the cash flow at this higher rate. It would be difficult for a company to keep this up forever, thus NPV is more accurate. NPV measures project value more directly than IRR. This is because NPV actually calculates the project's value. If there is more than one project lined up, the manager can simply add the values together to get a total. Often times, during the life of a project, cash flows must be reinvested to cover depreciation. This will give a negative cash flow for that period, thus leading to more than one IRR. If there is more than one IRR, than calculating only 1 IRR for the project is not reliable. NPV must be used for this type of project.

The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment; this method tends to favor smaller projects and is best used by firms with limited resources and high costs of capital.