Question

a) Is it possible for conflicts to exist between the NPV and the IRR when independent projects are being evaluated? Explain your answer. (150 words)

b) If the payback was the only method a firm used to accept or reject projects, what payback should it choose as the cutoff point, that is, reject projects if their paybacks are not below the chosen cutoff? Is your selected cutoff based on some economic criteria, or is it more or less arbitrary? Are the cutoff criteria equally arbitrary when firms use the NPV and/or the IRR as the criteria? Explain.(150 words)

c) Why do most academics and financial executives regard the NPV as being the single best criterion and better than the IRR? Why do companies still calculate IRRs?(150 words)

Answer 1

a) it often happens that conflicts exist between NPV ad IRR when dependent projects are evaluated. But, In independent projects, decision of one project does not affect other projects. So there is no great or major conflict between NPV and IRR.

NPV needs a discount rate and it will say whether cash flows will be positive or not based on the that rate. IRR is the actual rate of return and it is when NPV is zero. Hence, when evaluating an independent project, there can be multiple IRR and can make the decision difficult. In NPV, the decision to accept or reject comes easily. It is a yes or a no. Preferred method is NPV over IRR.

b) In payback period, we compare mutually exclusive projects. The project which has lesser or faster payback period. It is not an accurate or reliable method like NPV or IRR which evaluates cashflow as its base.But if we have to choose a cutoff point, it should be chosen based on time frame decided by the company and also by looking at time frame that similar profitable projects took to complete their projects.

Also, projects which require analysis of NPV, payback are usually big in size and volume like any construction project and hence a minimum period should of 3 years and arbitarily, cutoff period should be 4 years to gain all the investment on a project.

Cutoff criteria are more justifiable and not arbitary when using NPV or IRR because the hurdle rate is actual expectations from investors because they have paid a premium on and above the risk free rate and they deserve a fair return. NPV and IRR look at cashflows over the period of project and hence it is more valid and accurate.

c) NPV is a more realistic method than IRR because NPV method uses a reinvestment rate close to its current cost of capital. The hurdle rate or cost of capital is the actual expectations of the investors and hence financial executives regard NPV as best criterion to evaluate a project. IRR is when NPV is zero, IRR is the actual rate of return that a project has and it is necessary to know what is the actual return that the project is giving.

NPV gives a decision of yes or no but IRR tells how much return a project is giving out currently. IRR also doesnt take changing factors of discount rate into consideration. Therefore, NPV is a safe and better method.