If mutually exclusive projects with normal cash flows are being analyzed, the ne

Question

If mutually exclusive projects with normal cash flows are being analyzed, the net present value (NPV) and internal rate of return (IRR) methods agree. Projects Y and Z are mutually exclusive projects. Their cash flows and NPV profiles are shown as follows. NPV I Dollars] Year Project Y ProjectZ 0 $1,500$1,500 $900 $600 $300 $200 800 $200 $400 $600 4 $1,000 Project Y 400 Project Z 200 ost of capital (WACC) If the weighted average c for each project is 14%, do the NPV and IRR methods agree or conflict? -200 O The methods agree. 0 2 48 10 12 416 18 20 COST OF CAPITAL (Percent The methods conflict. A key to resolving this conflict is the assumed reinvestment rate. The IRR calculation assumes that intermediate cash flows are reinvested at the that the rate at which cash flows can be reinvested is the , and the NPV calculation implicity assumes As a result, when evaluating mutually exclusive projects, the is usually the better decision criterion.

Explanation / Answer

1)

sometimes

2)

NPV of project Y = -1,500 + 200 / ( 1 + 0.06)1 + 400 / ( 1 + 0.06)2 + 600 / ( 1 + 0.06)3 + 10,00 / ( 1 + 0.06)4  

NPV of project Y = $340.54

NPV of project Z = -1,500 + 900 / ( 1 + 0.06)1 + 600 / ( 1 + 0.06)2 + 300 / ( 1 + 0.06)3 + 200 / ( 1 + 0.06)4  

NPV of project Z = $293.36

IRR is the rate of return that makes NPV equal to 0

We use trial and error method to find IRR for both projects

Let's try R as 13.49

0 = -1,500 + 200 / ( 1 + R)1 + 400 / ( 1 + R)2 + 600 / ( 1 + R)3 + 1000 / ( 1 + R)4

0 = 0

Therfore IRR of project X is 13.49%

Let's try 17.07

0 = -1,500 + 900 / ( 1 + R)1 + 600 / ( 1 + R)2 + 300 / ( 1 + R)3 + 200 / ( 1 + R)4  

0 =0

Therefore IRR for project Z is 17.07%

The methods conflict

3)

Inernal rate of return

Requires rate of return

NPV

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