Question

Research Questions :

1) What causes conflicts in the ranking of projects via net present value and internal rate of return?

2) Does the assumption concerning the reinvestment of intermediate cash inflow tend to favor NPV or IRR? In practice, which technique is preferred and why?

Answer 1

ANSWER 1

For independent coventional projects there is no conflict between ranking the projects for NPV or IRR. But in case of mutually exclusive projects, there might be some conflict. Mutually exclusive projects are the projects are the set of projectsout of which only one project can be chosen for investment.

Two possible causes of conflict of raking may be

(a) different cash flow patterns

Project C and D have similar outlays but different patterns of future cash flows. Project C realises most of its cash flows in earlier years of investment

	cash flows
year	0	1	2	3	4	NPV	IRR(%)
project C	-200	80	80	80	80	53.59	21.86
Project D	-200	0	0	0	400	73.21	18.92

If both projects were not mutually exclusive we would have invested in both as both are profitable.

(b) different scale of project

Project C has much smaller outlay than project D, although they have similar future cash flow patterns.

	cash flows
year	0	1	2	3	4	NPV	IRR(%)
project C	-100	50	50	50	50	58.49	34.9
Project D	-400	170	170	170	170	138.88	25.21

If both projects were not mutually exclusive we would have invested in both as both are profitable.

ANSWER 2

The assumption concerning the reinvestment of intermediate cash inflow tend to favor IRR.

In practice NPV is favoured because when we discount a particular cash flow at a particular dicount rate, we assume that we can reinvest the cash flow at the same discount rate. The discount rate uses in NPV is oppotunity cost of funds . And in IRR calculation, the fact that we earned at a particular rate does not mean we can reinvest the cash flow at the same rate. So NPV calculation uses the most realistic discount rate.