NPV Over MIRR: Ranking Different Sized Mutually Exclusive Projects

Imagine you are deciding between two investment opportunities for your small business. Let’s say you have two choices: Project A, investing in a new high-tech coffee machine for your cafe, and Project B, expanding your cafe to a second location. Both are great ideas, but you can only choose one – they are mutually exclusive. You want to pick the one that makes your business more profitable.

To help with this decision, financial tools like Net Present Value, or NPV, and Modified Internal Rate of Return, or MIRR, are often used. Both attempt to measure the profitability of a project. Think of NPV as calculating the total net gain you expect to receive from the project in today’s dollars, after accounting for the initial investment and the time value of money. It’s like figuring out your total profit in present-day terms. MIRR, on the other hand, is like calculating the effective interest rate you’re earning on your investment, but with some important adjustments to make it more realistic than its older cousin, the Internal Rate of Return, or IRR.

Now, you might be wondering why MIRR, being a more refined version of IRR, is still considered less effective than NPV, especially when comparing projects of different sizes. Let’s delve into that.

The core issue lies in how each method measures and prioritizes value. NPV directly measures the absolute increase in wealth a project is expected to generate. It tells you, in dollars, how much richer your business will be if you undertake a project. For example, if Project A has an NPV of $50,000 and Project B has an NPV of $100,000, NPV clearly indicates Project B is more valuable as it adds $100,000 to your business’s worth compared to Project A’s $50,000.

MIRR, however, focuses on the rate of return. It essentially tells you what percentage return you’re getting on your investment, assuming cash flows are reinvested at a safe rate. While this percentage is useful, it can be misleading when comparing projects of different scales, much like comparing the interest rate on a small savings account to a large real estate investment. A higher percentage return on a smaller investment might look appealing, but it might not generate as much actual wealth as a slightly lower percentage return on a much larger investment.

Let’s go back to our cafe example. Imagine Project A, the coffee machine, requires a $10,000 investment and is projected to generate a MIRR of 20%. Project B, the second location, needs a $100,000 investment but is projected to generate a MIRR of 15%. At first glance, 20% sounds better than 15%. However, let’s consider the actual dollar gains. If Project A with a 20% MIRR generates a total NPV of, say, $15,000, and Project B with a 15% MIRR generates a total NPV of $80,000, the picture changes. Even though Project A has a higher MIRR, Project B adds significantly more value in absolute dollars, $80,000 versus $15,000.

This discrepancy arises because MIRR, while addressing some shortcomings of IRR, still expresses profitability as a percentage. Percentages are useful for relative comparisons, but when making decisions about mutually exclusive projects, especially those differing significantly in scale, absolute value creation is paramount. NPV directly addresses this by calculating the total present value of net cash flows, giving you a clear picture of which project adds more actual wealth to your business, regardless of the percentage return.

In essence, for mutually exclusive projects of different sizes, NPV is superior because it directly reflects the scale of investment and the absolute value created. MIRR, while a helpful metric, can sometimes lead to choosing a smaller, higher-percentage project over a larger, slightly lower-percentage project that ultimately generates significantly greater overall wealth. When deciding where to invest your limited resources, focusing on maximizing total value, as measured by NPV, is often the most financially sound approach.