Question

Why can the internal rate of return method give an answer in conflict with the net present value method?

Answer 1

• IRR is the discount rate at which net present value of future cashflow becomes zero. NPV is sum of discounted cashflow for entire life cycle of project .
• Internal rate of return ( IRR) and Net Present Value (NPV) method of capital budgeting, provides conflicting result, when mutually exclusive projects differ in size or timing of future cashflows. Mutually exclusive projects competes with other for acceptence,as only one of them can be accepted.
• Cashflow size difference : Consider two projects, one with larger size with higher cash flow and another of smaller size. A project with higher size usually earns lower return than a smaller size project. So, IRR will select the smaller project.Whereas, smaller project does not add enougn value to the company, so slection of larger project is necessary. In this case, NPV method is followed in the view of value added to company.
• Timing of future cashflow : When cashflow of project is concentrated in later period than the initial period than , IRR requirement of project becomes higher. So, due to cashflow pattern difference both provides conflicting return.