Question 2 (a)

Why NPV and IRR can rank projects differently, and which to prefer

6 marks

Time to write
About 12 minutes
Topic
Capital budgeting techniques

Question

Question 2 (a) · 6 marks

Why can the IRR and NPV methods result in different rankings of investment proposals? Which would you prefer in which situation, and why?

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

12 minfor 6 marks

Read from the question

  • Why…?Which…?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

  1. Read; underline the asks; jot your points 1 min
  2. 1 Reinvestment assumption 2 marks 3 min
  3. 2 Scale of outlay 1 mark 2 min
  4. 3 Pattern and life of cash flows 1 mark 2 min
  5. 4 Which to prefer and why 2 marks 3 min
  6. Check: every ask answered, key terms underlined 1 min

Short on time? Trim steps 1 and 4 evenly rather than skip one: each is capped at its own marks.

Try it first. About 12 minutes for 6 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.

For a single conventional project NPV and IRR give the same accept-or-reject decision. When mutually exclusive projects are ranked, the two can conflict, for three reasons:

  1. Different reinvestment assumptions. NPV assumes the intermediate cash flows are reinvested at the cost of capital; IRR assumes they are reinvested at the project's own IRR. IRR therefore favours projects with heavy cash flows in the early years over those whose flows come later.
  2. Size (scale) of the outlay. IRR is a percentage and ignores scale. A project with a larger outlay but a lower IRR may add more to shareholders' wealth in absolute NPV.
  3. Pattern and life of the cash flows. Projects with different inflow/outflow patterns or lives can be ranked differently, and unconventional flows may even give multiple IRRs.

Which to prefer.

  • NPV, in general and for mutually exclusive projects. It measures the absolute increase in shareholders' wealth and rests on the more realistic assumption of reinvestment at the cost of capital; IRR's choice of the highest rate may not be the most profitable or the one consistent with the firm's objective.
  • IRR for a single, independent proposal. For an independent project with conventional cash flows, the two methods give the same accept-or-reject answer, because the IRR exceeds the cut-off rate exactly when the NPV is positive; there the IRR may be used, since a percentage return is easily compared with the cut-off rate. Where funds are limited, the choice should still rest on the set of projects with the largest total NPV, not on the highest IRRs.

Where the 6 marks sit

#ComponentMarks
1Reinvestment assumption2
2Scale of outlay1
3Pattern and life of cash flows1
4Which to prefer and why2
Total6
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