Question

Explain why, if two mutually exclusive projects are being compared, the project that generates most of its cash flows in the beginning of its life might have the higher ranking under the NV criterion if the required rate of return is high, whereas the project that generates most of its cash flows toward the end of its life might be deemed better if the required rate of return is low. Would changes in the firms required rate of return ever cause a change in the IRR ranking of two such projects? Explain.

Answer 1

When two mutually exclusive projects are being compared, the required rate of return has an important role in taking decision. If the required rate of return is high, while discounting, the present value of cash flows will be high compared to the future year's value. The cash flows in the future years will be undergone high discount. So, the project that generates most of its cash flows in the beginning of its life will get higher ranking under the NPV criterion. This is because of the time value concept.

The opposite will happen if the required rate of return is low. The project that generates most of its cash flows toward the end of its life will be ranked higher.

IRR decision rule is based on the required rate of return of the project. If IRR is more than required rate of return, the project is considered to be profitable and will be ranked high. This is also an impact of time value of money. IRR is the rate at which the NPV is zero. The rate more than IRR, makes NPV negative, that is the project will be non profitable. So a project with rate of return which is less than IRR is to be ranked higher.

Thus, the changes in the firms required rate of return cause a change in the IRR ranking of two mutually exclusive projects.