Question

When evaluating mutually exclusive capital budgeting projects, the NPV and IRR could conflict with each other in the ranking of projects. List and explain three reasons why a conflict could exist. Which technique is best to use in a conflict? Explain.

Answer 1

1. Ans ) capital budgeting : is the process that a business uses to determine which proposed fixed assets purchase it should accept, and which should be declined .it is known as investment decision. It as long term in nature ,and irreversible in nature.

Capital budgeting techniques :  there are different types of techniques are used .some of are discounting techniques some are non discounting techniques .

1 )Net present value : NPV is calculated by taking difference between = Present value of inflows - present value of outfofws.

Strength of NPV : consider Time values of money .

Weakness of NPV : does not take into consideration the size of projects.

2 ) Internal rate of return : IRR is the rate of interest or discount rate that makes NPV =0 we normally accept the project if IRR > Ko.

Weakness of IRR : unrealistic rate reinvest ment assumptions tha calculation of IRR assume the cash flow are reinvested at the IRR not ko.

often both above techniques IRR and NPV conflict with each other . reason for conflicts are  

1. Nature of cash flow
2. Nature of projects
3. Size of projects

In case of conflicting results NPV decisions is considered the best decision .

because the NPV method uses a reinvestment rate close to its current cost of capital, the reinvestment assumption of NPV method are more realistic than those associated with the IRR method .NPV also have an advantage over IRR when a project has non normal cash flows.

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