Question

An intern from ASU at your firm is confused by the NPV and IRR rules in the capital budgeting process. Please provide an overview of how these rules work. Your answer should cover not only situations where the firm’s projects are independent or if they are mutually exclusive, but also when the two rules will be in agreement or disagreement.

Answer 1

When Firms; Projects are independent then both NPV and IRR provide same accept/reject decisions. When NPV is positive and when IRR is greater than cost of capital project should be accepted.

In mutually exclusive projects NPV should be used over IRR. Sometimes IRR might give conflicting results and it might result in wrongly accepting lower NPV Projects. NPV of higher project is accepted and not the project with higher IRR

This is because of following reasons:
1. IRR doesnot take into consideration the size or scale of project.
2. IRR method fails in case of non conventional cash flows where there is multiple changes in sign of cash flows.