Question

choosing between two projects. The cash flows for the projects are given in the following table​ ($ million):

Project Year 0 Year 1 Year 2 Year 3 Year 4

A negative $ 48

−$48 $ 24

$24 $ 21

$21 $ 19

$19 $ 15

$15

B negative $ 102

−$102 $ 20

$20 $ 41

$41 $ 48

$48 $ 58

$58

a. What are the IRRs of the two​ projects?

b. If your discount rate is

4.7 %

4.7%​, what are the NPVs of the two​ projects?

c. Why do IRR and NPV rank the two projects​ differently?

a. What are the IRRs of the two​ projects?

The IRR for project A is

Answer 1

As shown in the below calculations, IRR of project A is 25.65% and that of project B is 19.51%

Now, NPV @ 7% is $19.73 for project A and $35.93 for project B.

Why the difference. While IRR of a project may be higher, it means that the interim cash flows that we get (+ve cash flows starting year 1), are also invested at IRR, i.e. 25.65% which might not be true. Hence NPV is a better criteria to choose between different projects.

As an eg, if you invest $1 and get $2 at the end of year, it is 100% IRR return but you only gain $1 at the end of the year.

On the other hand if you invest $100 and get $150 at the end of the year, it is only 50% IRR return but you gain $50 in second case.