Question

You are considering two mutually exclusive projects. The NPV for project one is positive and higher than the NPV for project two, while the IRR for project two is higher than that for project one. Which project should the firm accept and why?

Answer 1

When the projects are mutually exclusive( acceptance of one means rejection of other) or non conventional ( cash outflow can incur in later years also), NPV and IRR may provide conflicting results.

There are limitations of IRR because of which the IRR method should not be chosen in case of conflict between NPV and IRR results. One of the basic limitation of IRR is it is based on the assumption that the intermediate cash inflows are re- invested at IRR rate itself. It means if a project which has IRR of 25 % will have reinvestment rate of 25 %. But this assumption is unrealistic because future is uncertain. We may not find a project for reinvestment which may provide the same rate of return as IRR of the concerned project. NPV method doesn't have any such assumption. It assumes that reinvestment will be at the cost of capital, which is quite realistic.

Also, NPV is an absolute measure, it will rank a project which will add more value to the firm (project whose net inflow is more)

Therefore, the firm should accept project 1 on basis of higher NPV.

Hope it clarifies!