Managerial Finance

THE APPLICABILITY AND USAGE OF NPV AND IRR CAPITAL BUDGETING TECHNIQUES
C.S. Agnes Cheng D. Kite R. Radtke
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C.S. Agnes Cheng D. Kite R. Radtke, (1994),"THE APPLICABILITY AND USAGE OF NPV AND IRR
CAPITAL BUDGETING TECHNIQUES", Managerial Finance, Vol. 20 Iss 7 pp. 10 - 36
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 10 Volume 20 Number 7 1994

THE APPLICABILITY AND USAGE OF NPV

AND IRR CAPITAL BUDGETING
TECHNIQUES
by C.S. Agnes Cheng, D. Kite, and R. Radtke, Department of Accountancy and Taxation,
College of Business Administration, University of Houston.

1. Introduction

Capital budgeting plays an essential role in a firm's long-term viability and survival. The
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capital budgeting process includes: identification of potential projects, prediction of

possible outcomes, project selection, financing and implementation of the chosen project,
and monitoring project performance (Mukherjee and Henderson, 1987). Although eco-
nomic considerations should govern the capital budgeting decision, individual opinions
and preferences often become primary factors affecting project selection.

Various capital budgeting techniques have been developed (Bierman and Smidt,
1993, Chapters 4 and 5; Horngren and Sundem, 1990, Chapter 12). Some simple ap-
proaches focus on accounting profitability, such as the Accounting Rate of Return,
Residual Income and Benefit/Cost Ratio. Others employ time value analysis of profitabil-
ity, such as the Net Present Value (NPV) and Internal Rate of Return (IRR) methods.
Additionally, methods ranging from the simple payback period method to sensitivity
analysis and simulation techniques have been developed to handle risk.

Financial theory indicates that a capital budgeting technique or decision rule should
meet specific criteria, such as wealth maximization, consideration of the time value of
money, systematic risk accommodation and generation of optimal rankings of mutually
exclusive alternatives (Moyer, McGuigan and Kretlow, 1984, Chapter 1). It is generally
agreed that discounted cash flow approaches are more consistent with these criteria than
simpler approaches.

NPV and IRR are the most popular discounted cash flow (DCF) methods. While both
methods are theoretically sound, each measures a different aspect of a capital project's
profitability. NPV measures the change in the net worth of the firm due to the project
while IRR measures the periodic rate of return for the project's required capital invest-
ment. At this stage of our knowledge, it appears appropriate to investigate cases when the
two methods generate conflicting results as to project acceptance and prescribe the best
method for each specific case. In cases when practitioners use a different method than the
method advocated by academicians, reasons for such a discrepancy should be explored.
The main purpose of this paper is to review the pertinent literature to contrast the
theoretical applicability and practical usage of NPV and IRR and to evaluate the reasons
for any discrepancy.
 Managerial Finance 11

The paper is organized as follows. The second section compares NPV and IRR from
a normative viewpoint. Because both NPV and IRR have unique advantages, researchers
have attempted to combine the advantages of both. These modified methods are described
in the third section. The fourth section reviews existing survey studies and analyzes the
empirical evidence on NPV and IRR use. Potential reasons for the observed empirical
evidence are examined in the fifth section. The final section summarizes the findings and
discusses directions for future research.

2. The applicability of NPV versus IRR

This section reviews pertinent literature to compare the applicability of NPV and IRR.
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The comparison begins with the single project case and extends to mutually exclusive
projects and capital rationing cases.

2.1 Single project case

The calculation of NPV is affected by four parameters: the economic life (T), the cash
flow pattern (xt, t=l ....T), the initial outlay (x0) and the cost of capital (COCt). The cost
of capital is equivalent to the financing cost (e.g., the market interest rate of borrowing or
lending, Hirshleifer, 1958, p. 330) and is affected by project risk and other characteristics.1

The IRR is the interest rate that equates the present value of the benefits of a project
with the present value ofthe costs. The calculation of IRR is affected by three parameters:
the economic life (T), the cash flow pattern (xt, t=l,...T) and the initial outlay (x 0 ). The
cost of capital (i.e., the hurdle rate or required rate of return) does not enter into the IRR
formula; therefore its determination can be delayed until project selection. While NPV
and IRR are equivalent with respect to the investment decision (accept or reject) for a
single project, they differ from both theoretical and procedural perspectives. These
differences are summarized in Table 1.

NPV is expressed explicitly as the effect of an investment on the firm's wealth

position. Consequently it is easier to reconcile NPV with the objective of wealth maximi-
zation, even though it is not always reconcilable.2 On the other hand, IRR generates an
interest rate that is useful in evaluating the project's profitability, but is only implicitly
associated with wealth. In cases when it is necessary for wealth to be explicitly evaluated
(for example, the case of an additive wealth effect), IRR is not applicable. Another
theoretical difference between NPV and IRR stems from the assumption regarding the
reinvestment rate (i.e., rate of return on future projects). Research has explored the
appropriateness of this assumption and has investigated its effect on the ranking of
mutually exclusive projects (discussed in the next section). It is generally believed that
NPV's reinvestment rate assumption is more realistic than that of IRR (Chow and
McNamee, 1991, p. 36).3
 12 Volume 20 Number 7 1994

Table 1
Comparison of the NPV and IRR method

Perspectives NPV Method IRR Method

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Theoretical Perspectives:
1. Consistency with Wealth Maximization Explicit Implicit
2. Reinvestment Rate Assumption Generally applicable Specifically applicable
Procedural Perspectives:
1. Information Requirement Requires all parameters for Delays the requirement of COC
calculation
2. Calculation Method Direct Method Trial and Error
3. Consideration of variations in COCt Easy and meaningful Difficult and sometimes
inapplicable
4. Implementation of inflation Flexible Inflexible and sometimes
inapplicable
5. Alternating signs of cash flows Can be incorporated Sometimes no solution or
multiple solutions
 Managerial Finance 13

NPV and IRR differ on several dimensions. First, the NPV calculation requires all
four parameters (life, cash flow pattern, initial outlay and cost of capital) while the IRR
calculation does not require cost of capital information (the hurdle rate can be determined
in a subsequent stage). Second, calculation of NPV is easier than IRR; the former employs
a direct calculation method based on all the known parameters, while the latter requires a
trial and error method (although this difficulty is mitigated with the use of computers).
Third, when there is a need to consider future cost of capital variations, the IRR method
is generally inapplicable since the IRR is usually considered to be constant throughout the
project life (and IRR does not have a time subscript).4 Of course, multiple IRRs may be
calculated, but the trial and error calculation procedure becomes extremely cumbersome
(Hirshleifer, 1958, pp. 346-351; Kim, Crick and Kim, 1986, p. 52). Fourth, if inflation is
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considered in capital budgeting decisions, the NPV method is more flexible since cash
flows (or the cost of capital) can be valued in both nominal and real terms. With IRR, on
the other hand, the nominal value method is less straightforward, especially when the
inflation rate varies over time. In the case of the tax effect of depreciation, the nominal
dollar method is preferable (Horngren and Sundem, 1990, pp. 763-766). Finally, if net
cash flows alternate in sign more than once between periods, there may not be a solution
or there may be multiple solutions of IRR. In the latter case, the meaning of IRR is difficult
to explain (Bierman and Smidt, 1993, pp. 94-98).

2.2 Mutually exclusive projects case

2.2.1 Reinvestment rate assumption and ranking inconsistency

The differences in NPV and IRR are not problematic if the methods give consistent results,
as in the single project case. However, NPV and IRR may generate inconsistent decisions
when dealing with mutually exclusive projects. Many studies have addressed the causes
of this inconsistency. The "reinvestment rate assumption" has generated the most attention
(Hirshleifer, 1958; Dudley, 1972; Meyer, 1979; Walker, 1983; Beidleman, 1984; Howe,
1985; McDaniel, McCarty and Jessell, 1988).

To reconcile the differences caused by the competing reinvestment rate assumptions,

Dudley (1972) developed the Fisher rate for the comparison of two projects. The Fisher
rate is based on Fisher's (1930) rate of return over cost, which is the discount rate that
causes two income streams obtainable from the same initial outlay to have the same present
value. Dudley (1972) suggested that, when a set of projects has a Fisher rate, the terminal
values (the future value calculated at the assumed reinvestment rate) of the projects could
be used to rank the projects as a benchmark for evaluating the applicability of NPV and
IRR. 5 When the reinvestment rate is less than the Fisher rate, NPV leads to the selection
of the project with the greatest terminal value. Alternatively, if the reinvestment rate is
greater than the Fisher rate, IRR leads to selection of the project with the greatest terminal
value.
 14 Volume 20 Number 7 1994

This literature generally concluded that the superiority of the NPV or IRR method in
the case of inconsistent rankings of mutually exclusive projects is dependent upon the
assumption of the reinvestment rate. If a firm's reinvestment rate of cash flows is closer
to the cost of capital (internal rate of return) employed by NPV (IRR), then NPV (IRR)
is superior. While the reinvestment rate assumption may be situation dependent (e.g.,
foreign investment and domestic investment may have different reinvestment rates), it is
helpful to understand the tendencies (or biases) in project selection which result when
NPV is used in the place of IRR (or vice versa).6

2.2.2 Effect of project characteristics on ranking inconsistency

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Variations in any of the three project characteristics previously identified (i.e., T, pattern
of xt,xoor COCt) may provide inconsistent rankings of acceptable projects under NPV and
IRR. IRR tends to favor projects with shorter lives (Wilner, Koch and Klammer, 1992),
smaller initial outlays (Chow and McNamee, 1991) and earlier cash flows. In addition,
IRR tends to generate inconsistent rankings as compared to NPV when the cost of capital
is low. The effect of these variations can be evaluated using a formal modeling approach,
but here simple examples are used to illustrate the relation between project characteristics
and ranking inconsistencies between NPV and IRR. The examples used in this section
(see Table 2) are modifications of those from Moriarity and Allen (1991, pp. 391-394).

From Table 2, it can be seen that project A requires twice the investment of project
B. In this case the IRRs are identical, while project A's NPV is twice that of project B.
Between projects A and C, NPV favors the longer-lived project while IRR favors the
shorter-lived project. Projects D and E show that NPV favors a later pattern of cash flows
while IRR favors an earlier pattern. The degree of inconsistency between NPV and IRR
depends on the magnitude and correlation of the differences in project characteristics. This
can be seen by comparing projects F and G for the combined effects of varying all three
project characteristics. Project F is the smallest project, has the shortest life and earliest
cash flows. In contrast, project G is the largest project, has the longest life and latest cash
flows. The project acceptance decisions based on NPV and IRR for these two projects are
highly inconsistent.

2.3 Capital rationing for multiple independent projects

Formal multiple project capital rationing models employ complex nonlinear algorithms
and are difficult to solve. A more practical approach is to rank all projects by the magnitude
of NPV or IRR and select the combination of top-ranking projects that exhausts the capital
budget and has a higher total NPV or composite IRR than any other combination.
However, such a simple decision rule may not be optimal because it ignores project
interdependencies. Since the capital budgeting rationing problem involves discrete pro-
jects, a combination of the top projects may perform worse than a combination of the
lower ranking projects (Moriarity and Allen, 1991, pp. 393-394; Bierman and Smidt, 1993,
Chapter 8). Nonetheless, the applicability of NPV or IRR for practical ranking under
 Managerial Finance 15

Table 2
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Example Project Information

Project

Year A B C D E F G

0 $(100,000) (50,000) (100,000) (200,000) (200,000) (30,000) (250,000)

1 40,000 20,000 30,000 0 0 22,000 0
2 40,000 20,000 30,000 0 0 22,000 0
3 40,000 20,000 30,000 0 300,000 3,000 0
4 40,000 20,000 30,000 0 0
5 30,000 0 0
6 30,000 430,000 0
7 600,000

NPV 26,795 13,397 30,658 42,724 25,394 10,436 57,895

IRR 21.86 21.86 19.91 13.61 14.47 33.75 13.32

NPVs in this table are calculated using a 10% discount rate.

 16 Volume 20 Number 7 1994

capital rationing has not been explicitly investigated. Bierman and Smidt (1993, p. 195)
suggest that IRR or the present value index can be used to generate a reasonable ranking
of projects. Such a ranking may help to select an initial set of projects whose net present
value may be compared to other sets. The set with the maximum net present value should
be selected.

This section compared the applicability of NPV and IRR in various contexts. The
following section discusses variations of these methods.

3. Variants of discounted cash flow methods

Although NPV may be theoretically preferred, in some cases IRR's annualized, yield-like
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presentation format may make it more desirable. Consequently, researchers have at-
tempted to combine the advantages of NPV and IRR to produce annualized or yield-like
figures which also consider wealth maximization. This section reviews and evaluates
modified methods. Two approaches are discussed: annualized capital budgeting methods
and modified rate of return approaches.

3.1 Annualized capital budgeting methods

Different methods have been proposed to modify NPV into an annualized figure. Bierman
and Smidt (1993) illustrated the usefulness of the annual equivalent cost in generating
cost comparisons between projects. The annual equivalent cost is an annual capital
recovery factor which considers the time value of money and is calculated by dividing the
initial outlay of the project by the present value annuity factor (for the life and required
return of the project). It focuses on project costs and assumes straight-line capital recovery
and a constant interest rate. Techniques such as this are useful under incomplete informa-
tion where they save time and effort, but result in a less precise analysis of the decision-
making situation (Bierman and Smidt, 1993, p. 173).

To consider the annualized project benefits, Truitt (1983) suggested the Annualized
Capital Budgeting Profit (ACBP) method. ACBP is equal to the difference between the
anticipated cash inflows and the annualized cost of a project. According to Truitt, the
ACBP method is consistent with NPV while generating an annualized figure that is easily
understood. It also may be used to compare projects with unequal lives. However, Burnie
(1985) showed that possible conflicts can arise between NPV and ACBP, particularly if
there are uneven cash flows. In addition, he reported that ACBP ignores the timing of cash
flows and allocates project cost on an arbitrary capital recovery basis.

Meyer, Besley and Longstreet (1988) suggested using the annualized net present
value (ANPV) method to analyze mutually exclusive investments, especially when
projects have unequal lives. The ANPV is the amount of the annual annuity over the life
of the project which would have a present value equal to the project's net present value.
 Managerial Finance 17

This measure is calculated by dividing the net present value of the project by the present
value annuity factor (for the life and required return of the project). The appropriate
investment choice is the project with the largest ANPV.

These annualized capital budgeting methods convert the NPV to an annuity. This
annualized figure is intuitively appealing; however, it masks information regarding the
timing of cash flows. For limited cases, (e.g., comparable projects with uniform cash flows
and unequal lives), the annualized method provides a convenient supplement for NPV
but should not be used as a replacement.

3.2 Modified rate of return approaches

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Since a yield-based capital budgeting method is intuitively appealing and more easily
compared to prevailing ratio measures (Sweeney and Mantripragada, 1987; McDaniel,
McCarty, and Jessell, 1988), conversion of NPV to a ratio format may be warranted.
Research has explored either the modification of IRR or the design of a rate of return
measure that generates capital budgeting decisions that are consistent with those of NPV.
This section reviews a few of these methods.

Sweeney and Mantripragada (1987) developed the modified internal rate of return
approach (MIRR) to ensure that IRR and NPV produced equivalent decisions. Their study
focused on the case of mutually exclusive investments with equal lives and evaluated the
cases of varying cash flow patterns and different investment costs. In the case of ranking
conflicts when using the MIRR, one project is considered the norm (or benchmark) while
the cash flows of the other are modified by borrowing/repaying at the chosen discount
rate (the firm's cost of borrowing or lending funds). The two IRRs are then compared
(normal and modified) to determine the superior project. According to the authors, the
MIRR approach permits a firm to use the rate of return concept and yet make decisions
that are consistent with the goal of wealth maximization. MIRR is very restrictive because
it only applies to two mutually exclusive projects and implementation of the borrowing/re-
paying rule can be cumbersome. Therefore, although this method allows the decision
maker to use a ratio format that can generate rankings consistent with NPV, its practical
use is limited.

McDaniel, McCarty and Jessell (1988) reviewed several yield-based capital budget-
ing methods. They proposed that for a yield- based capital budgeting technique to be
consistent with wealth maximization, it must meet the following criteria: 1) give a unique
solution for every project, 2) maintain risk-equivalence so that it may be compared to the
marginal cost of capital, 3) include the idea that capital funds differ from operational cash
flows, 4) give the same accept/reject decision as NPV for every project, 5) rank projects
with unequal size in the same order as NPV, 6) rank projects with time disparity in the
same order as NPV and 7) rank projects with unequal lives in the same order as NPV.
They reviewed several proposed methods based on these criteria and proposed a modified
method, termed marginal return on invested capital (MRIC) method. This method satisfied
 18 Volume 20 Number 7 1994

all the criteria except number 5, which was conceptually impossible for a yield-based
capital budgeting technique assigning a single measure to each project (p. 378).

Their marginal return on invested capital (MRIC) is:

where ao = present value of capital funds at the marginal cost of capital (αo< 0)
t = time
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h = planning horizon period

at = net operating cash flow
k = marginal cost of capital.

The derivation of MRIC is based on the terminal value of a project. The terminal
value is calculated by compounding each operational cash flow at the marginal cost of
capital. The MRIC is developed in three steps. The first step requires management to
determine the planning horizon (h) for capital budgeting since a common period is needed
for calculating terminal values (the summation term in the brackets) of all projects. The
second step is to separate the cash flows into required capital funds and operating cash
flows. The capital cash flows are discounted to the present using the marginal cost of
capital (to generate ao). The operating cash flows are compounded over the planning
horizon to generate the terminal value. The third step is calculating the MRIC using the
equation above.

The computation and interpretation of the MRIC is simple and devoid of IRR's
cumbersome calculations and interpretations. According to the authors, the MRIC is
consistent with NPV wealth maximization, maintains risk equivalence, eliminates ranking
problems caused by unequal lives and time disparity, generates a unique yield and gives
the same accept/reject decisions as NPV.

The MRIC method effectively transforms NPV into an annualized ratio. It is theo­
retically sound and intuitively understandable. However, it has a few drawbacks. First, it
requires a planning horizon and a specified reinvestment rate which are not required with
IRR. Second, for the MRIC to generate conclusions consistent with NPV, the reinvestment
rate must be the marginal cost of capital. Finally, because this method combines the present
values (for cash outflows) and terminal values (for cash inflows), it may induce a
misleading interpretation of the MRIC.

The justification for using modified rate of return approaches stems from the need
for a yield-based measure that is consistent with NPV. To evaluate the usefulness of
MRIC, it should be compared with the popular yield measure based on NPV, the
 Managerial Finance 19

profitability index ratio: net present value divided by capital investment. In developing a
new yield-based measure, a comparison to the profitability index ratio is warranted.

In principle, the annualized methods and the modified rate of return methods provide
practical ways to deal with complicated capital budgeting decisions. However, neither of
these methods can replace NPV or IRR unconditionally. Empirical evidence on the usage
of NPV and IRR is now investigated.

4. NPV and IRR use: An analysis of survey reports

This section reviews a set of survey studies and explores the empirical evidence regarding
practitioners' use of NPV and IRR. The main analysis focuses on the differences in the
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popularity (measured by relative percentage of use) of NPV and IRR.

4.1 Popularity of NPV and IRR - US case

Table 3 summarizes the results of surveys of US-based companies regarding the relative
application of NPV and IRR. The survey results are summarized in the order of the period
(as discernable) in which each study was conducted. For each study, the year, firm type,
firm size, sample size, use of IRR and NPV and the survey question type are reported.

The survey articles reported in Table 3 mainly cover large, publicly-traded companies
between 1978 and 1988. The weighted average for all questions reveals that 56.3% of
respondents used IRR and 29.9% used NPV, a 26.4% difference. All surveys reviewed,
except survey 5, show that IRR was used more often than NPV. Reconciling results from
different survey studies is constrained by the differences in questions asked, instruments
used, the timing of the survey and sample configuration. For example, the results reported
by survey 5 may be different than the other surveys due to differences in sample
composition. The firms in survey 5 were smaller (with assets from $1 million to over $100
million) than those in other surveys. The potential factors, including size, which may drive
the differences in survey results are explored in the next section.

4.2 Factors affecting survey results - US case

While a more formal statistical analysis of the survey reports could be applied (e.g.,
meta-analysis: Glass, McGraw and Smith, 1981; Mullen, 1989) to evaluate the effect of
various factors, the relatively small number of studies limits the ability to perform such
an analysis. Instead, simple statistics are reported to highlight differences among surveys.

4.2.1 Question type

Two broad types of survey questions have been employed to investigate the use of capital
budgeting techniques: exclusive and overlapping. The exclusive category basically asks
the respondent to choose one method (e.g., respondents are asked to identify the "primary"
method used). In contrast, the overlapping category asks subjects to identify all important
 20 Volume 20 Number 7 1994

Table 3
Use of IRR and NPV - US Firms

Study Year Sample IRR NPV Difference Survey Quantity

af Firm Firm Firm Size Size Use ­­­
Type Survey Size Rank

(1) 1978 Sales $15-50 medium 209 36% 18% 18% overlapping
Million
Medium-sized
Midwestern firms
from D&B Million
(2) I978 Dollar Directory large 125 83% 67% 10% overlapping
Largest US and US-sales
European US 500 Mill
Multirewards Eu-top total
sales

(3) 1980 Fortune 500 largest large 121 83% 165% 488% exclusive
Multirewards Medium
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Sales 523
Bill

(4) 1981 Fortune 500 largest 729% Cap largest 193 66% 10% 56% exclusive
individuals Bud ≥ 50
M i l . 54%
>100 Mill

(5) 1984 S&P Lx of OTC

Stocks
Avg. Assets
$83 Mill
medium 180 48.3% 575% -8.7% overlapping

(6) 1984 Major US R&D firm Mean Saleslarge 117 73% 59% 14% overlapping
(Business Week)
$1353 Mill
(7) 1985 Fortune 1000 net available large 367 49% 21% 28% exclusive

(8) 1986 Fortune 500 83% sales largest 102 56.9% 127% 28% exclusive
>5500 Mill

Average 177 563% 29.9% 260%

Studies include: (1) Christiansenand Ferrel 1980/81; (2) Baker 1987; (3) Survey and Block 1983; (4) Hendricks 1983: (5) Pope 1 9 8 6 / 8 7 ; ( 6 ) Cook and Rizzaro 1 9 8 9 ; ( 7 ) Kim, Cock and Kim
1986 and (8) Cooper Cornick and Rechno 1992.
 Managerial Finance 21

methods used (i.e., respondents are able to choose more than one method). Referring to
Table 4, there are four surveys each grouped in the exclusive (3, 4, 7 and 8) and
overlapping (1, 2, 5 and 6) categories.

It is apparent that the exclusive category demonstrates a stronger IRR preference than
the overlapping category. The exclusive group shows a weighted average use of 56.7%
for IRR and 16.5% for NPV (a 40.2% difference). The overlapping group, on the other
hand, shows a much smaller difference (55.8% - 46.5% = 9.3%). It appears that firms may
use both IRR and NPV; but, when they are asked to compare the relative importance of
the two, IRR is the more popular primary method.

The difference between the exclusive and overlapping categories may be influenced
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by other factors. However, comparing the studies between the two categories with respect
to time, firm size and other characteristics (summarized in Table 4), it appears that the
two groups are similar in all aspects except firm size. Thus, firm size effect is investigated
in more detail.

4.2.2 Firm size

Of the studies reported in this paper, four specifically examined the relationship between
firm size and capital budgeting method. The results of these studies are summarized in
Table 5. Stanley and Block (1983, study 3) found large firms more likely to use IRR and
less likely to use NPV as the primary evaluation technique. The remaining three studies
(all overlapping) were less conclusive. All showed an increased use of IRR as firm size
increased, but the difference between IRR and NPV use was less pronounced than Stanley
and Block (1983, study 3). The ratio of IRR use approached that of NPV use because the
respondents did not have to choose (or exclude) a unique method.

The relationship between size and method choice was also evaluated across studies.
Firms in the samples of the eight studies summarized in Table 3 include Fortune 500,
Fortune 1000, Major US R&D, Industrial, Multinational and OTC firms. While the size
measures are not directly comparable among the studies, a rough ranking was derived. In
Table 3, the firm size descriptions contained in the survey reports are provided along with
these rankings. 8 Table 4, section 2 reports the use of DCF methods when differences in
company size were considered. Within the overlapping category, the medium group
reported smaller differences in the use of IRR and NPV (5.6%) than the large group
(15.0%). Within the exclusive category, the large group reported smaller differences in
the use of IRR and NPV (33.2%) than the largest group (51.9%). In addition to the
difference between IRR and NPV use the percentage of IRR use was positively correlated
with firm size within both the overlapping (41.9% for medium and 78.2% for large ) and
exclusive (53.0% for large and 62.9% for largest) categories.

The exclusive group was used to further investigate the size effect across studies. It
was determined that, since the exclusive question distinguishes the extent of use between
IRR and NPV better than the overlapping question and since the samples included in the
 22 Volume 20 Number 7 1994

Table 4
Use of IRR and NPV and US Survey Characteristics

Searching Time Question Type Firm Size Other N' Avg. Avg. Differences
IRR Uses
NPV Use
1. B y Questions Type

1,2,5,6 exclusive 783 567% 165% 40.2%

2large 2 dirty 1 reason
2 less 2 largest
3,4,7,8 2 curty overlapping 2 medium
survival 63% 55.8% 46.5% 9.3%
2 large 1 reason
2 less survival
2. By Size.
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1. 5 2 overlapping
medium 389 41.9% 36.3% 5.6%
1 curty
1 less
2.6 1 smarty 2 overlapping large 1 medium- 242 78.2% 63.1% 11.0%
rational
1 less

3.7 1 smarty
1 less
2 exclusive large 488 53.0% 19.9% 33.2%
1 medium-
rational
4.3 1 smarty 2 exclusive largest 295 62.9% 10.9% 51.9%
1 less

3 . By Time

1,2,3,4 cuerty 2 exclusive 2 medium- 648 59.5% 24.8% 34.7%

2 overlapping national
(78-81) 1 medium
2 large
1 largest

5,6,7,8 less 766 53.7% 34.3% 19.4%

(86-88) 2 exclusive 1 medium
2 overlapping 2 large
1 largest

4 . Effect of Multiclinical operations

23 2 lusty medium- 246 74.3% 4.22% 32.1%

2 largest
1 overlapping monomial
1 overlapping

1.4 1 nasty 1 exclusive Mixed 4•02 50.4% 14.2% 36.2%

1 overlapping 1 medium
1 largest
6.7 2 less 1 exclusive 2 large Mixed 484 54.8% 30.2% 24.6%
1 overlapping

Studies include: (1)ChristiansonandFurrel1980/81;(2)Baker1987;(3)StanleyandBlock1983;(4)Hendricks1983.(5)Pope1986/87;(6)CookandRizzuro1989: (7)KimCrickandKim

1986and(8)Cooper,CornickandRedman1992.

1
"N" represents the t o t a l combined sample for the respective
category.
 Managerial Finance 23

Table 5
An Analysis of Capital Budgeting and the Size Effect

Sample
DUR Study Year Sample sample Characteristics NPV DifferenceSurvey Question
Size Uses Uses

C(1) 1978 209 Number of Employee: overlapping

Small: 0-25 27% 27% 0%

Medium-sized
Midwestern Medium: 26-100 27% 13% 14%
firms from
D&B Million
Large: 101-250 41% 18% 23%
dollar
Directory
(3) 1980 Midwesternal 121 Firm Size (Medium Sales exclusive
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Fortune 1000 $23 bill range $100 mill to

firms 108 bill):

lst Quarter
43% 20% 23%
2nd Quarter
69% 17% 52%
3rdQuarter
72% 21% 51%
4thQuarter
83% 10% 73%

(5) 1984 180 AssetSize: overlapping

S&P list of
OTC stocks $ l ≤ $ 2 0 mill (57) 31% 57% -26%

$20≤$50 mill (58) 43% 53% -10%

$5O≤$100 mill (30) 67% 63% 4%

Over$100mill(35) 72% 61% 11%

(6) 1984 117 Sales: overlapping

Major US
R&D firms $100 million or less 59% 53% 6%
(Business
Weak) $100.1-$1000 million 75% 53% 19%

$1000- million 83% 72% 11%

Studiesincludes:(1)ChristiansonandFerrel1980/81:(3) Stanley and Block 1983: (5)Pope1986/87; (6)CookandRizzuro1989.

 24 Volume 20 Number 71994

exclusive category are more homogeneous, this investigation should provide better insight.
Within the exclusive category, four studies sampled Fortune 500 and Fortune 1000 firms
between 1980 and 1988. The results of these studies (Studies 3,4, 7 and 8) are presented
in Figure 1. The percentage of IRR use reported by Fortune 500 (Fortune 1000) firms
respectively is represented by Line 1 (Line 2), while Line 3 (Line 4) depicts the percentage
of NPV use reported by Fortune 500 (Fortune 1000) companies. It is apparent that even
though both Fortune 500 and Fortune 1000 companies prefer IRR to NPV, the percentage
of IRR use and the difference between IRR and NPV use are smaller for Fortune 1000
companies. While the samples all include large companies, Fortune 500 companies are
considerably larger than Fortune 1000 companies. The differences between Fortune 500
and Fortune 1000 companies further confirm the association between size and capital
budgeting method choice.
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An interesting trend for both Fortune 500 and Fortune 1000 companies to switch from
IRR to NPV exists; however, the trend is much weaker for Fortune 500 companies. This
Figure 1
Use of IRR and NPV for Fortune 500 and 1000 Firms

0 Fortune 500 - IRR

• Fortune 500 - NPV
D Fortune 1000 - IRR
■ Fortune 1000 - NPV
 Managerial Finance 25

trend may be due to sample differences rather than time. For example, study 3 focused on
Fortune 1000 multinationals while study 7 consisted of Fortune 1000 companies (not all
multinationals). Further investigations of usage trends are explored next.

4.2.3 Usage trend

As indicated in Figure 1, a trend of switching from IRR to NPV exists for both Fortune
500 and 1000 firms. To further investigate this trend, in section 3, Table 4, studies are
identified as early (1978 to 1981) and late (1984 to 1988). A comparison of early and late
studies reveals that use of IRR decreased and use of NPV increased over time. The early
group showed a difference in use of IRR and NPV of 34.7% while the late group showed
a difference of 19.4%. This trend may be caused by other confounding factors. To explore
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this possibility, the factors between the groups were contrasted. The composition of
samples described in Table 4, section 3, shows that the only difference is that two early
group studies surveyed multinational firms. While the other samples did not specifically
focus on multinational firms, some multinational firms might have been included. If this
was the case, the difference between the samples would be mitigated. Although it is
debatable whether the trend is due to the multinational firms in the early sample, the effect
of multinational operations is explored next.

4.2.4 Effect of multinational operations

Two studies (survey 2, overlapping and survey 3, exclusive) explicitly identified the
sampled populations to be multinational firms. These firms were contrasted with two other
sets of studies to investigate the potential effect of multinational operations on capital
budgeting method choice: early studies (1,4) and late studies (6, 7) (see section 4, Table
4). The results show that, while multinational firms tend to report the highest use of IRR,
the difference in use of IRR and NPV over time does not appear to be effected by the
inclusion of multinational firms in the sample.

4.2.5 Popularity of NPV and IRR - non-US case

The focus of capital budgeting studies outside of the US ranges from capital budgeting
methods used to risk assessment practices (see Table 6). The articles reported cover large
companies outside of the US, but size categories similar to those used for US firms cannot
be identified due to lack of information and the inherent difficulties in translating global
currencies into US dollars.

Table 6 shows the relative application of NPV and IRR for the non-US surveys. In
general, the results are similar to US results; all countries except Australia exhibit a
preference for IRR. The weighted average use is 51.5% for IRR and 40.3% for NPV, an
11.2% difference. As with US surveys, the differences in the surveys may emanate from
different questions, instruments, timing and samples. Unlike the US surveys, however,
the results are further confounded by inter-country differences. Consequently, the results
of analyses similar to those conducted for US firms would be invalid. For example, the
 26 Volume 20 Number 7 1994

Table 6
Use of IRR and NPV - Foreign Firms

Study Country Year of Firm Type Sample IRR NPV Difference Survey
Study Size Use Use Question

(9) UK 1975 Largest 150 42% 32% 10% overlapping

manufacturing
and retail

(10) Australia 1979 not available 96 66% 52% 14% overlapping

(11) Canada 1980 Corporations 208 38% 22% 16% exclusive

on the
Financial Post
Industrials list
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(12) UK 1980/1981 Largest 150 54% 38% 16% overlapping

manufacturing
and retailing
companies

(13) Australia 1983 Firms from 98 47 % 44% 3% overlapping

three sources:
Australian
Stock
Exchange
listing,
Australian
Business Top
500 1982 and
State
Government
listings

(14) Canada 1985 Corporations 208 40% 25% 15% exclusive

on the
Financial Post
Industrials list

(15) UK 1986 Largest 100 75% 68% 7% overlapping

companies

(16) Australia 1988 IBIS Top 500 113 72% 75% ·3% overlapping
Corporations

Average 112 50.9% 39.9% 11%

Studies include: (9) Pike 1983:(10)McMahon1981: (11) Blazouske, Carlin and Kim 1988; (12) Pike 1983; (13) Lilleyman 1984; (14) Blazouske,
Carlin and Kim 1988; (15) Pike and Sharp 1989 and (16) Freeman and Hoboes 1991.

"This study was included in Freeman and Hobbes (1991).

 Managerial Finance 27

differences between studies asking overlapping and exclusive questions are confounded
by country differences. The study surveying Canadian capital budgeting use is the only
study which asks an exclusive question. Therefore, further comparisons on this dimension
are not possible. It appears that the only comparison made among US surveys which is
also possible among foreign surveys is the usage trend. Analysis of the foreign surveys
over time exhibits no discernable pattern. In other words, there is no relationship between
IRR and NPV use and time (between 1975 and 1989). However, breaking the analysis
into countries and analyzing intra-country trends shows a usage trend in Australia. The
difference between IRR and NPV usage declined over time (14% in 1979, 3% in 1983
and -3% in 1988). Another interesting intra-country trend was revealed for both Canada
and the UK. In both of these countries, the use of both IRR and NPV increased over time.
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Unlike Australia, Canada and the UK, Japan's capital budgeting methods do not
appear to be consistent with the US. Hodder's (1986) study of Japanese capital budgeting
methods revealed that use of discounted cash flow methods is low. However, this study
differs from the other studies in both sample composition and research design. Therefore,
further investigation of intercountry differences on capital budgeting techniques and
choices is warranted.

5. Causes of different NPV and IRR usage

Based on the previous analysis, it is apparent that firm size is associated with the choice
of NPV and IRR. Firm size may serve as a proxy for firm characteristics which, in turn,
cause the IRR preference. This section summarizes a few studies that have investigated
the possible reasons for practitioners' preference for IRR.

5.1 Convenience

Executives find IRR intuitively appealing because it measures investment worth in

percentage terms, which can be readily compared across projects. The IRR determination
is also considered to be more convenient than NPV because a discount rate (cost of capital)
is not needed for the calculation. Based on these explanations smaller firms should prefer
IRR to NPV, since larger firms should have sufficient planning staffs which are capable
of performing more "sophisticated" analyses (Christiansen and Ferrell, 1978). However,
this prediction conflicts with the finding that larger firms prefer IRR.

5.2 Capital budget size, project type and risk

Studies have explored the relationship between capital budgeting methods, capital budget
size and project type. For example, using a sample of 300 of the Fortune 500 largest
industrial firms, Hendricks (study 4, Table 3) found a significant positive relationship
between IRR usage and the size of the capital budget. Fifty-four percent of firms with
annual capital budgets less than $100 million used IRR as the primary technique. On the
 28 Volume 20 Number 7 1994

other hand, 86% of those with annual capital budgets greater than $100 million used IRR
as the primary technique.

Cook and Rizzuto (study 6, Table 3) surveyed the use of IRR and NPV by major US
R&D firms. They specifically investigated how capital budgeting methods varied with
different types of R&D projects (e.g., non-R&D, development, basic and applied projects).
ing upon project type. For non-R&D projects, 73% used IRR and 59% used NPV, a 16%
difference. For R&D projects, the results differed depending on the level of development
of the project. For basic projects, 11.1% used IRR and 3.9% used NPV, a 7.2% difference.
The ratios of IRR, NPV and their differences are 28.5%, 22.9% and 5.6% for applied
projects and 66%, 49% and 17% for development projects. It appears that the use of DCF
techniques is related to the stage of development, and therefore the uncertainty, of a
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project. Basic projects which have unpredictable results use DCF methods the least, while
the use of DCF methods increases as the certainty of the development and application
increases. Theoretical or empirical evidence on the relation between estimation certainty
(or project type) and capital budgeting method choice is sparse and deserves further
attention.

When NPV and IRR generate inconsistent rankings, IRR favors projects with smaller
initial outlays, shorter lives and earlier cash flows. If projects with larger initial outlays,
longer lives and later cash flows are considered risky, IRR may be considered as a
technique to mitigate the risk. Previous researchers have focused on adjusting cash flows
or the cost of capital to accommodate risk, but none have explored the use of IRR. For a
risk-averse decision maker, IRR may coincide better with the decision maker's risk
attitude. Miller (1987) explained IRR's popularity as a function of uncertainty. He showed
that NPV may not give correct project recommendations in the presence of uncertainty.
Consequently, Miller stated, it is better to use decision rules specifying the minimum
acceptable safety margins, perhaps in the form of a minimum acceptable profitability ratio.
Payback,10 accounting rate of return, IRR and the profitability ratio all give the manager
some feel for the size of the safety margin, according to Miller. The relation between risk
and IRR popularity points to an interesting avenue for future research.

5.3. Contingency theory

A contingency theory perspective may be used to explain the relationship between IRR
preference and company size. Hayes (1977) described a contingency framework which
hypothesized that the effectiveness of certain organizational measures was dependent
upon internal, interdependency and environmental factors. In the capital budgeting
context, different-sized firms' divergent capital budgeting methods may imply that a
capital budgeting method's effectiveness is contingent upon certain firm characteristics.
Haka (1987) investigated the effectiveness of discounted cash flow techniques (DCFT)
using a contingency paradigm. She found that a firm's performance was superior when it
used a DCFT and had one of the following: 1) predictability of the financial markets and
 Managerial Finance 29

competitors' actions, 2) decentralized capital investment decision-making authority or 3)

capital budget preparer's perception of a long-term reward structure (as opposed to a
short-term focus). Although Haka did not investigate the relative applicability of IRR and
NPV, her findings indicate that contingency theory offers a promising avenue for future
research.

5.4 Agency theory

Agency theory has also been applied to capital budgeting. Chaney (1989) analytically
examined the effect of moral hazard on capital budgeting. He found that in some cases of
moral hazard, NPV rankings changed to favor projects with a faster payback and suggested
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that the effect of moral hazard depended upon project uncertainty, the disutility of effort
and the length of the contracting horizon. Pike (1985) also used an agency theory approach
to study capital budgeting techniques. He hypothesized that the choice of capital budgeting
method arose from the conflict between manager and owner interests. If the manager was
concerned with stockholder welfare, then payback should be less preferred since it is not
a wealth-maximizing method. His hypothesis was supported as his results showed a
negative relationship existed between the importance of the payback method for capital
budgeting decisions and the importance of the shareholder wealth objective.

The agency approach could be adopted to study IRR preference. One possible agency
explanation for IRR popularity may stem from contracts between managers and stock-
holders of large firms. For the last 50 to 70 years, return on investment (ROI) has been
the most popular method of performance evaluation (Lander and Bayou, 1992). This type
of evaluation may lead managers to choose investment projects which improve their
performance evaluation. Since it may be easier for managers to predict an investment's
effect on ROI, using IRR(as opposed to NPV), this may explain the popularity of IRR.

6. Summary

From a theoretical perspective, NPV is considered superior to IRR. The former is

compatible with wealth maximization and makes realistic reinvestment rate assumptions.
However, while the calculation of IRR is more complicated than NPV , IRR is more
convenient because the cost of capital need not be specified. Academicians, in general,
prefer NPV to IRR; however, they do not recommend NPV over IRR in all situations.
Researchers have attempted to modify the presentation format of NPV so as to produce
either an annualized amount or a ratio format; however, none of the modified methods
can substitute for NPV or IRR unconditionally.

Despite the theoretical superiority of NPV over IRR, this paper finds practitioners
prefer IRR. A systematic analysis of the survey results conducted in the last fifteen years
shows that larger firms prefer IRR more than smaller firms. Over time, the preference for
 30 Volume 20 Number 7 1994

NPV is increasing while the preference for IRR is decreasing. Types of questions asked
(exclusive or overlapping) do not affect the general conclusions.

In light of the theoretical superiority of NPV, the practical preference of IRR is

puzzling. Few studies have investigated reasons for this discrepancy. Anecdotal evidence
points to the "convenience" of IRR and the "understandability" of the ratio measure of
IRR as an explanation of its popularity. Based on these conjectures, smallerfirmsshould
prefer the more convenient and understandable method. However, results show that larger
firms favor IRR more than smaller firms. Without further research, reconciling these
conflicting results is difficult. Promising directions for this research include evaluating
the potential effects of project risk and applying the conceptual framework suggested by
contingency and agency theories.
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When theory conflicts with practice, an investigation of the underlying reasons for
the discrepancy is warranted. Studies investigating this conflict are surprisingly rare. The
potential benefits of such an inquiry depend on the wealth (cost or benefit) effects of the
discrepancy. Measuring the cost or benefit of using IRR instead of NPV is difficult;
however, empirical evidence may provide a basis for inference. If the cost or benefit of
using one method over another is minimal, a systematic difference in NPV and IRR use
should not exist. In contrast, if NPV is not theoretically better than IRR, a time trend of
increasing NPV usage should not be found.

The findings of this paper point to the need for an overall framework to delineate
appropriate capital budgeting methods for specific contexts. Although it may not be
possible to designate methods for all situations, guidance can be given based on charac-
teristics such as risk and firm size. The development of this framework should be based
onfieldstudies, interviews and surveys with practitioners. Since the results of this paper
suggest that researcher's prescriptions are ignored by practitioners, such a positive
approach may yield more useful conclusions than a normative approach.
 Managerial Finance 31

Footnotes

1. For example, Talmor and Thompson (1992) suggest increasing the discount rate to deal
with uncertainty and decreasing the rate if profitable-dependent future investments exist.

2. Woods and Randall (1989) posit that when there is information asymmetry between
management and the market, a divergence exists between the market value of shares and
true shareholder wealth, i.e., between the NPV of a project and the resultant gain in
shareholder wealth. Brigham and Tapley (1985) contend, however, that for most large,
public companies, investors correctly anticipate the total value expected to be added by
management through the capital budgeting process. In this case the effect of information
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asymmetry is dissipated, since the (assumed) increase in total value is accurately reflected
in the company's current stock price.

3. The NPV method is consistent with the assumption that the reinvestment rate is the cost
of capital, which is generally applicable to current and future projects, while the IRR
method is consistent with the assumption that the reinvestment rate is the internal rate of
return, which tends to be associated with a specific project. The reinvestment rate
assumption of IRR is more suitable only in instances where a firm has investment
opportunities that are as profitable as the current project.

4. A firm may choose to apply different risks with respect to the timing of cash flows so
that multiple COCs or IRRs are desired. For example, Chow and McNamee (1991) pointed
out that it is not unreasonable to argue that more distant cash flows are more risky;
however, the opposite may hold since projects usually are introduced in phases. For
example, a new service may be more risky in earlier phases.

5. According to Beidleman (1984, p. 129), a pair of projects will only have a Fisher rate
if the plots of each project's NPV versus discount rate intersect in the first quadrant.
Therefore, not all pairs of projects will have a Fisher rate.

6. Many studies (Dudley, 1972; Howe, 1985) concluded that in the case of unlimited
capital, the reinvestment rate should be the firm's cost of capital. Consequently, NPV is
preferred. However, Meyer (1979) pointed out that the average rate of return on new
investments is the correct reinvestment rate in the case of unlimited capital. In this case,
IRR is superior for project selection. In the case of capital rationing, however, the problem
is more complex due to such factors as the interdependence of projects and the instability
of the marginal rate of return.

7. Bierman and Smidt (1993) discussed the comparability of mutually exclusive invest-
ments: "A group of mutually exclusive investments will be said to be comparable if the
profitability of subsequent investment possibilities will be the same, regardless of which
investment is accepted or if all are rejected" (p. 162).
 32 Volume 20 Number 7 1994

8. The ranking is subjectively determined. First, on average, Fortune 500 firms are larger
than Fortune 1000 firms. While both Fortune 500 and 1000 firms are large, they are
labelled as largest and large. Second, Fortune 1000 firms are compared with firms in
other studies and two large and two medium samples are identified. The studies could
have been divided among small, medium and large. However, one of the studies with the
smallest firms among the studies identified its firms as "medium-sized" firms. Therefore,
to remain consistent with the actual description, the smallest sample firms in this review
are ranked as medium.

9. Cook and Rizzuto (1989) defined R&D projects as follows: basic research - "investi-
gation to gain knowledge for its own sake", applied research - "investigation directed
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toward obtaining specific knowledge with commercial applications and translation of

techniques and scientific knowledge into concrete new products and processes" and
development - "translation of techniques and scientific knowledge into concrete new
products and processes" (p. 293).

10. Surveys have shown that the payback method is the most popular secondary capital
budgeting method (Cooper, Cornick and Redmon 1992; Kee and Bublitz 1988; Kim, Crick
and Kim 1986; Posey, Roth and Dittrich 1984; Stanley and Block 1983).
 Managerial Finance 33

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