Question 2 OR (b)

The IRR method, and why NPV and IRR can conflict

9 marks

Time to write: About 18 minutes
Topic: Capital budgeting techniques

Question

Question 2 OR (b) · 9 marks

Explain the IRR method of capital budgeting decision. Why the NPV and IRR techniques lead to a conflict in project ranking?

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

18 minfor 9 marks

Read from the question

Explain…Why…?Two asks in one question: answer both. Where it asks why, give reasons, not a description.
IRRCash flows year by year in one table, then discount, then a one-line decision.

Write it in this order

Read; underline the asks; jot your points 1 min
1 IRR: meaning and computation 3 marks 5 min
2 IRR: decision rule, merits and limitations 2 marks 4 min
3 Reasons for conflict and preferred method 4 marks 7 min
Check: every ask answered, key terms underlined 1 min

123

Easy marks

Step 1 opens with the meaning: a one-line definition, the quickest mark in it.

Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.

Try it first. About 18 minutes for 9 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

The IRR method. The internal rate of return, also called the yield on investment or marginal efficiency of capital, is the discount rate at which the present value of a project's cash inflows equals its cash outflows, i.e. NPV = 0. Like NPV it allows for the time value of money, but the rate is found from the project's own cash flows rather than given in advance.

Computation: try discount rates until the PV of inflows is just above and just below the outlay, then interpolate between the two rates.
Decision: accept the project if its IRR exceeds the cut-off rate (cost of capital); if equal, the firm is indifferent.
Merits: it considers the time value of money and the cash flows over the whole life, and a rate of return is easily understood.
Limitations: tedious calculation; possibly multiple rates; and for mutually exclusive proposals the highest IRR may not be the most profitable.

Why NPV and IRR can rank projects differently

Reinvestment assumption. IRR assumes intermediate cash flows are reinvested at the project's IRR, NPV at the cost of capital; IRR therefore favours projects with heavy early cash flows.
Scale of investment. IRR is a percentage and ignores size; a larger project with a lower IRR may add more NPV.
Timing and life of cash flows. Projects whose flows come at different times or last for different periods can be ranked differently.

When the methods conflict, NPV is preferred, as it measures the absolute increase in shareholders' wealth and rests on the more realistic reinvestment rate.

Where the 9 marks sit

#	Component	Marks
1	IRR: meaning and computation	3
2	IRR: decision rule, merits and limitations	2
3	Reasons for conflict and preferred method	4
	Total	9

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