ANSWER(b) When you are analyzing a single conventional project, both
NPV and IRR will provide you the same indicator about whether to accept
the project or not. However, when comparing two projects, the NPV and IRR may
provide conflicting results. It may be so that one project has higher NPV while
the other has a higher IRR. This difference could occur because of the
different cash flow patterns in the two projects.
The following example illustrates this point.
Project
A

Project
B


Year 0

5000

5000

Year 1

2000

0

Year 2

2000

0

Year 3

2000

0

Year 4

2000

0

Year 5

2000

15000

NPV

$2,581.57

$4,313.82

IRR

29%

25%

The above example assumes a discount rate of 10%.
As you can see, Project A has higher IRR, while Project B has higher NPV.
If these two projects were independent, it wouldn’t
matter much because the firm can accept both the projects. However, in case of
mutually exclusive projects, the firm needs to decide one of the two projects
to invest in.
When facing such a situation, the project with a
higher NPV should be chosen because there is an inherent reinvestment
assumption. In our calculation, there is an assumption that the cash flows will
be reinvested at the same discount rate at which they are discounted. In the
NPV calculation, the implicit assumption for reinvestment rate is 10%. In IRR,
the implicit reinvestment rate assumption is of 29% or 25%. The reinvestment
rate of 29% or 25% in IRR is quite unrealistic compared to NPV. This makes the
NPV results superior to the IRR results. In this example, project B should be
chosen.
The above example illustrated the conflicting
results of NPV and IRR due to differing cash flow patterns. The conflicting
results can also occur because of the size and investment of the projects. A
small project may have low NPV but higher IRR.
Project
A

Project
B


Year 0

5000

20000


Year 1

2000

7000


Year 2

2000

7000


Year 3

2000

7000


Year 4

2000

7000


Year 5

2000

7000


NPV

$2,581.57

$6,535.51


IRR

29%

22%


In this case, Project A has lower NPV compared
to Project B but has higher IRR. Again, if these were mutually exclusive
projects, we should choose the one with higher NPV, that is, project B.
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