Question

When the management team considers what projects to continue with, there are positive NPV projects and negative NPV projects. Based on the readings for this week, what are the differences between these two projects? What are some problems with the IRR methodology compared to the NPV methodology?

Answer 1

A positive NPV project implies that the project has greater discounted cash inflows as compared to cash outflows. This means that the project is adding value to the business. A negative NPV project means that the project has greater discounted cash outflows rather than inflows. This project will erode the value of the business and hence should not be undertaken.

The major problem With IRR methodology is that in situations when the cash flows are nonconventional there are multiple IRRs. In this case it is difficult to determine the correct internal rate of return. Moreover this methodology is not suitable when the scale of the projects are different. It will only provide the rate of return and does not provide the value added by the project. Hence in case of comparison between two projects of different scales, it may be possible that the project with the lower IRR has a greater NPV which will make it more preferable than the other.