Question

WEEK 2: Discussion Prompt #1 After watching the following video, discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.

https://www.youtube.com/watch? v=6RztxNwerOA

Answer 1

NPV and IRR giving Conflicting Rankings

When comparing two projects, the NPV and IRR may provide conflicting results. It may be so that one project has higher NPV while the other has a higher IRR. This difference occurs because of the different cash flow patterns in the two projects.

If these two projects are independent, it wouldn’t matter much because the firm can accept both the projects. However, in case of mutually exclusive projects, the firm needs to decide one of the two projects to invest in. In such case, the project with a higher NPV should be chosen.

This is because there is an inherent reinvestment assumption. In NPV method, there is an assumption that the cash flows will be reinvested at the same discount rate at which they are discounted. In IRR, the implicit reinvestment rate is the IRR value itself, which could be sometimes unrealistic compared to NPV. Further IRR does not really take the scale of the Cash Flows into account. These factors make the NPV results superior to the IRR results.

Example

Let us assume two projects A and B with the cash flows shown below. We assume discount rate of 10%

• Both A and B have NPV>0, suggesting that both are acceptable.
• Both A and B have IRR>required rate of return, suggesting that both are acceptable.

If the company is to accept one of A and B-

• NPV method suggests Project B since NPV of B>NPV of A
• IRR method suggests Project A since IRR of A>IRR of B

In this case we go by NPV and select Project B.

The video also discusses about Multiple IRR problem, discussed as beow

No IRR or Multiple IRRs

When the cash flow streams from a project are unconventional i.e. additional cash outflows occur later during the project life in addition to the initial outlay, an IRR might not exist, or there might be multiple IRRs. This is because cash flow changes in direction can give more than one roots of the equation. This is common in capital budgeting since many projects require additional investments later during the project for maintenance repairs etc. So, If the project has unconventional cash flows, then there may exist more than one IRR. In these cases, NPV is preferred over IRR.

We discuss some more relative strengths of NPV and IRR over each other

Advantages of NPV

• The NPV method produces a dollar amount that indicates how much value the project will create for the company. Stakeholders can see clearly how much a project will contribute to their value.
• The calculation of the NPV uses a company's cost of capital as the discount rate. This is the minimum rate of return that shareholders require for their investment in the company.

Disadvantages of NPV

• NPV method is not applicable when comparing projects that have differing investment amounts. A larger project that requires more money should have a higher NPV, but that doesn't necessarily make it a better investment, compared to a smaller project.

Advantages of IRR

• With the IRR method, the advantage is that it shows the return on the original money invested, which is compared with the required rate of return.

Disadvantages of NPV

• No IRR or Multiple IRR problem (as discussed before)
• NPV and IRR giving Conflicting Results (as discussed before)