Question

Consider my cost of capital is 4%. I have got three projects to choose from.

A)
NPV = -49000
IRR = 5.5%

B)
NPV = -40000
IRR = 6%

C)
NPV = -55000
IRR = 5%

One can observe that all NPV'sare negative but IRRwise projects are good. Kindly advise regarding how to critically evaluate the projects to choose the best one.

Answer 1

Net present value is mostly used in making capital budgeting decisions. Net present value helps to find out if the projected future cash flows cover the future cost of starting and running a business. It helps to understand how much an investment or project is worth. It is because of all this, that net present value is the tool of choice for financial analysts. It gives them a clearer picture in making capital budgeting decisions.

Internal rate of return cannot be used as an evaluation tool in capital budgeting analysis when comparing mutually exclusive projects.Internal rate of return will give a percentage interpretation which is not enough. Net present value is used in case of mutually exclusive projects.

The IRR and NPV ranks projects differently because NPV assumes that project cash flows are reinvested at the discount rate while, IRR suffers from the limitation that it assumes that project cash flows are reinvested at the internal rate of return.

None of the projects can be selected since they have all generate a negative net present value.