Question

Which of the following statements is FALSE?

		a. When using the incremental IRR rule, you must keep track of which project is the incremental project and ensure that the incremental cash flows are initially positive and then become negative.
		b. When the risks of two projects are different, only the NPV rule will give a reliable answer.
		c. Problems arise using the IRR method when the mutually exclusive investments have differences in scale.
		d. Picking one project over another simply because it has a larger IRR can lead to mistakes.

Answer 1

Let us consider two projects: Project A and B.

Both projects A and B are of different size and scale as we can see from the initial cost.

Consider the NPV as 5 %

Project	Initial Cost	Payoff after 3 years	IRR	NPV
A	$200,000	$250,000.00	7.64%	$15,959
B	$40,000	$60,000.00	14.32%	$11,830

Calculations of IRR: ((FV/PV)^{^1/n} -1)

where FV=Payoff after 3 years, PV=Initial Cost, n= Number of years for receiving payoff i.e.3

Calculation of NPV for Project A: Discounted Value of Payoff after 3 years-> (250000/1.05^{^3})=215959

NPV=215959-200000= 15959

Calculation of NPV for Project B: Discounted Value of Payoff after 3 years-> (60000/1.05^{^3})=51830

NPV=51830-40000= 11830

Here, IRR of Project B > IRR Project A

However, NPV of Project A > NPV of Project B

Hence, Project A gives more cash flow to the company than Project B.

Hence,Picking one project over another simply because it has a larger IRR can lead to mistakes.

Problems can arise using the IRR method when the mutually exclusive investments have differences in scale as seen above.

Hence, When the risks of two projects are different, only the NPV rule will give a reliable answer.

When using the incremental IRR rule, you must keep track of which project is the incremental project and the incremental cash flows can be positive or negative but then they should ensure it later becomes positive so that the company realises that project is beneficial

Hence, the Answer is A.