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

Mutually exclusive projects means the firm has to make a decision to select one project and reject another. In Mutually exclusive projects acceptance of one means rejection of other.

In case of mutually exclusive projects, the NPV and IRR could conflict with each other in the ranking of projects. Below are the some reasons of conflict -

1) IRR and NPV may rank projects differently when the projects has unequal life. Since the IRR is as scaled measure it is biased for smaller projects which are more likely to provide higher return than larger projects. In larger projects the NPV will be more the the cash inflows will be for more no. of years. So in case of unequal life IRR and NPV may rank projects differently.

2) When there is time disparity for the cash flows of two different projects IRR and NPV may rank projects differently.

3) IRR and NPV may rank projects differently due to size disparity also. IRR will prefer the project which are smaller in size but NPV will be more of larger investment project.

--->When there is conflict between the NPV and IRR techniques in respect to ranking of the projects, NPV method should be used. IRR mthod is based on assumption that the intermediate cashflows are reinvested at IRR, which is unrealistic.

NPV has realistic reinvestment rate assumption. It assumes all the intermediate cash inflows are reinvested at cost of capital. Hence, NPV is a better technique to be used in case of conflict.

Hope it explains!