Question

• Prompt: Net present value and internal rate of return – Many businesses use both present value and internal rate of return to rank the potential profitability of investments (projects). When is it possible to for these approaches to provide conflicting rankings of mutually exclusive investment projects? In other words, when do these approaches provide different rankings when considering investing mutually exclusive projects?
• Requirements: 250 words

Answer 1

Solution:-

Both NPV and IRR are two of the most widely accepted methods used for capital budgeting decisions by financial managers.

NPV refers to the net present value of a project's cash flows discounted at the cost of funds to be discounted. A positive NPV means that the rate of return of the project is higher than cost of capital, hence the project is financially feasible and vice-versa.

IRR or internal rate of return simply refers to the actual rate of return of the project. If IRR is higher than the project's cost of capital, it means the project is financially viable and vice-versa.

When multiple mutually exclusive projects are to be ranked based on their attractiveness, the NPV and IRR methods may give different results and it is due to the following reasons:

1) Different projects may have different useful lives which results in difference in rankings. For e.g- A project which has a 10 year useful life may have higher overall NPV than a project that has 5 year life, however the IRR of the shorter project may be higher than the IRR of 10 year project

2) Varying cash flow patterns is one of the most common reasons of contradictory results between NPV and IRR. Different projects have different patterns of cash flows during their lives, such as consistent cash flows, heavier cash flows in the initial stages and lighter flows in later stages, entire inflow in one go at the end of project, etc. Due to these variations in cash flow projects among projects, NPV and IRR may give conflicted rankings

3) Different size of projects is another reason of conflict between NPV and IRR. E.g.- A larger project (with larger cash flows) may have higher NPV while the smaller project may have a higher IRR.

Therefore, due to above reasons the comparative ranking exercise of projects may have different results using NPV and IRR methods.