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In ordinary circumstances, the two discounting approaches will result in identical investment decisions. However, there are differences between them that can result in conflicting answers in terms of ranking projects according to their profitability.

In formal accept/reject decisions, both methods lead to the same decision, since all projects having a yield in excess of the cost of capital will also have a positive net present value.

 

Example

 

Project A and B both require an outlay of Rs 1000 now to obtain a return of Rs 1150 as the end of year 1 in the case of A, and 1405 at the end of year 3 in the case of B. The cost of capital is 8%.

Internal rate of return                   A = 15%

                                                          B =  12%

Net present value               A = (1150 x 0.926) - 1000 = Rs.65

                                                          B = (1405 x 0.794) - 1000 = Rs.115

 

Both project have rates of return in excess of 8% and positive net present value; but on the basis of the internal rate of return method, project A is superior, while on the basis of the net present value method, project B is superior.

 

Confusion arises because the projects have different lengths of the life, and if only one of the projects is to be undertaken, the internal rate of return can be seen to be unable to discriminate satisfactorily between them. As with any rate of return, there is no indication of either the amount of capital involved or the duration of the investment. The choice must be made either on the basis of net present values, or on the return on the incremental investment between projects.

 

The two methods make different implicit assumptions about the reinvesting of funds received from projects–particularly during the "gaps" between the end of one and the end of another.

 

The net present value approach assumes that cash receipts can be reinvested at the company's cost of capital, thereby giving a bias in favor of long-lived projects. In contrast, the internal rate of return approach assumes that cash receipts are reinvested at the same rate, giving a bias in favor of short-lived projects.

 

It follows that the comparison of alternatives by either method must be made over a common time period, with explicit assumptions being made about what happens to funds between their receipt and the common terminal date.