Question

You have two mutually exclusive projects A and B and have constructed the NPV profiles for these projects. You find that the IRR of A is greater than the IRR of B but at an 8% cost of capital using the NPV method you would prefer project B. What is causing the NPV profile pattern that you are observing? Which project do you prefer and why? Essentially you are preferring one method over another so you need to discuss the deficiencies of rejected method for full marks.

Answer 1

What is causing the NPV profile pattern that you are observing?

The two projects have different cash flow pattern. Project B must be having higher proportion of cash flows coming in later years while Project A has higher proportion of cash flows in earlier years. The situation is depicted in the graph below. The blue line is Project A which has higher IRR than Project B represented by red line. The diagram is for the purpose of illustration. The figures have no meaning.

· B’s NPV profile is steeper than A’s. This is because B’s cash inflows are further from starting point. Hence, impact of increase in hurdle rate is more prominent in case of B. B’s NPV declines at a faster rate when hurdle rate increases.

· At the hurdle rate = cross over rate, both the projects have the same NPV.

· B has higher NPV if hurdle rate < cross over rate.

· A has higher NPV if hurdle rate > cross over rate.

· Which project has a higher NPV depends on what hurdle rate is used to discount the cash flows to their present value in the analysis, and the dividing point is the crossover rate.

· When discounted at hurdle rates < the crossover rate, NPV and IRR give different results.

· When discounted at hurdle rates > the crossover rate, the NPVs and the IRRs give the same result.

Which project do you prefer and why?

This is the problem with IRR when the timing of cash flows of mutually exclusive projects is different. It can give results that conflict.

In case of a mutually exclusive projects, only one of the proposed projects can be accepted by the company. How do we resolve the conflict if we must choose one or the other?

• The convention is to use the NPV rule when the two methods are inconsistent, as it better reflects our primary goal: to grow the financial wealth of the company.
• NPV is a more reliable evaluation tool, because it results in an absolute amount of profit.
• Find out which of the proposed projects has the highest NPV at the given cost of capital (hurdle rate) and the same should be selected.
• In this case, at 8% cost of capital, Project B has higher NPV and hence Project B should be selected.