7. Understanding conflicts between methods If projects are mutually exclusive, o

Question

7. Understanding conflicts between methods If projects are mutually exclusive, only one project can be chosen. The internal rate of return (IRR) and the net present value (NPV) methods will not always choose the same project. If the crossover rate on the NPV profile is below the horizontal axis, the methods will agree Projects W and X are mutually exclusive projects. Their cash flows and NPV profiles are shown as follows NPV (Dollars Year Project W Project X 800 $1,000 $1,500 $350 $500 $600 $750 $200 $350 $400 $600 600 Project X 400 4 Project W 200 If the weighted average cost of capital (WACC) for each project is 10%, do the NPV and IRR methods agree or conflict? 200 O The methods agree 0 2 4 6 8 10 12 14 16 18 20 COST OF CAPITAL (Percent The methods conflict.

Explanation / Answer

If the cross over rate on NPV profile is below the horizontal axis , the methods will always agree as seen from the divergence in the two graphs that Project W has both higher IRR and NPV

If the WACC of each project is 10% it is clear that Project X has a higher NPV as compared to Project W and methods conflict as project W has higher IRR than Project X but lower NPV.

IRR assumes that intermediate cash flows are reinvested at Internal rate of return, and NPV assumes that cash flows are reinvested at required rate of return.

As a result, when evaluating Mutually exclusive projects , the NPV method is usually the better decision criterion.

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