When a company uses the Internal Rate of Return (IRR) instead of the Net Present Value (NPV) to evaluate investment projects, there are several things that can be lost. Here are a few examples:
1. Timing of cash flows: IRR does not consider the timing of cash flows, whereas NPV takes into account the time value of money by discounting future cash flows to their present value. This means that IRR may not accurately reflect the profitability of an investment over time, especially if the cash flows are unevenly distributed.
2. Scale of investment: IRR does not take into consideration the scale of the investment. For example, two projects with different initial investments but the same IRR may have significantly different NPVs. NPV considers the absolute value of the cash flows, which is useful for comparing projects of different sizes.
3. Reinvestment assumption: IRR assumes that any positive cash flows generated by the project will be reinvested at the project's IRR. However, this may not be realistic in practice. NPV, on the other hand, allows for different reinvestment rates, which can provide a more accurate assessment of the project's profitability.
4. Mutually exclusive projects: If a company has multiple investment options and needs to choose between them, IRR may lead to incorrect decisions. This is because IRR assumes that cash flows from one project can be reinvested at the same rate as the IRR of another project, which may not be feasible. NPV, on the other hand, can help determine the best investment option by considering the absolute value of the cash flows.
In summary, while IRR is a useful tool for evaluating investment projects, it has limitations when compared to NPV. NPV takes into account the timing, scale, reinvestment assumptions, and allows for the comparison of mutually exclusive projects. Therefore, it is important for companies to consider both IRR and NPV when making investment decisions to ensure a comprehensive evaluation of the potential returns.