Question

From Martland (2012) 9.1 A dispute has broken out in a board meeting of a real estate investment firm. Mr. Park advocates developing a site as a parking lot that would require a minimal level of investment, produce revenues of close to $1 million per year, and have an IRR of more than 40%. Mr. Macy prefers a mixed development with several small stores at street level and apartments on the upper levels. He argues that the project will have a NPV of $6 to $10 million, using the company’s hurdle rate of 15%. ‘‘Fine,’’ says Mr. Park, ‘‘but your IRR is still less than 20%, so my project is better.’’ Which project would you support? and why?

Answer 1

IRR simply gives the internal reinvestment rate at which the NPV of the project will be zero. So the Project of Mr Park will have zero NPV when the 40% discount rate is used. It does not specify the actual amount of NPV which is very important to know. If the IRR is more than hurdle rate, the NPV will be positive , but the Amount of NPV cannot be ascertained as the value will depend on the investment and cash flows. There fore, Mr Park's project details only indicate that there will be positive NPV but the NPV amount is not known. So we do not know how much will be the net return in $ term from the investment based on IRR only.

Mr Macy's Project on the other hand in much more specific and it indicates a $6-10 Million NPV using the 15% hurdle rate. So we can understand clearly that the wealth of investors will increase by $6-10 Million from the project. This gives a much clear and objective information without any ambiguity.

So Mr Macy's project is preferable as it provides the information in an objective way that helps to select the project because the NPV is positive and quantified.