Question

NPV versus IRR. Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation. Both projects require an annual return of 15 percent. Year Fishing Submarine 0 -835000 -1650000 1 450000 1050000 2 410000 675000 3 335000 520000 As a financial analyst for the company, you are asked the following questions. a) If your decision rule is to accept the project with the greater IRR, which project should you chose?

b) Since you are fully aware of the IRR rule’s scale problem, you calculate the incremental IRR for the cash flows. Based upon your computation, which project should you choose?

c) To be prudent, you compute the NPV for both projects. Which project should you choose? Is it consistent with the incremental IRR rule?

Answer 1

a.

IRR is the rate at which NPV = 0

Fishing:

-83500 + 450000/(1+IRR)^1 + 410000/(1+IRR)^2 + 335000/(1+IRR)^3 = 0

By trail and error, IRR = 0.2149 = 21.49%

Submarine:

-1650000 + 1050000/(1+IRR)^1 + 675000/(1+IRR)^2 + 520000/(1+IRR)^3 = 0

By trail and error, IRR = 0.1977 = 19.77%

Choose project Fishing, since IRR is higher

b.

Incremental cash flows are calculated as the difference in two project's cash flows

Year 0, -1650000 - (-835000) = -815000

Year 1, 1050000-450000 = 600000

year 2, 675000-410000 = 265000

Year 3, 520000-335000 = 185000

-815000 + 600000/(1+IRR)^1 + 265000/(1+IRR)^2 + 185000/(1+IRR)^3 = 0

IRR = 0.1765 = 17.65%

Since IRR is greater than required return, choose high cost project which is Submarine

c.

NPV:

Fishing:

-83500 + 450000/(1+0.15)^1 + 410000/(1+0.15)^2 + 335000/(1+0.15)^3 = $86591.19

Submarine:

-1650000 + 1050000/(1+0.15)^1 + 675000/(1+0.15)^2 + 520000/(1+0.15)^3 = $115348.89

Choose Submarine, since NPV is higher. This decision is consistent with incremental IRR rule.