Validity of NPV Rule and IRR Criterion for Capital Budgeting and CBA

The validity of the NPV rule and the criticisms against IRR are evaluated using a capital amortization approach (CA) and the results presented. Negative or zero or no IRR is consistent with the net cash flow (NCF) when the sum of NCF is either zero or negative. Reinvestment, with non-normal NCF, causes spurious NPV and multiple IRR. These problems are resolved by eliminating reinvestment. With normal NCF, reinvestment affects NPV, in some cases, but not the IRR. Finally, IRR can rank mutually exclusive projects and can be estimated either as a return on the total or balance of the capital. The NPV can be used with normal NCF investment and the result will be consistent with the IRR. The question is whether the investors are interested to base their decision on the return as a percentage (IRR) or as an absolute money value (NPV) or as per dollar of investment (BCR or PI). The caution is that even with normal NCF, the NPV does involve reinvestment (at low discount rates) but not the IRR. Also, while ranking mutually exclusive investments with normal NCFs, the ranking by NPV changes with discount rates but ranking by IRR is consistently unique. With non-normal NCFs, the NPV is spurious and IRR not unique. The CA approach discussed in this paper resolves this problem by eliminating reinvestment. The NPV rule, therefore, needs revisiting