Question

In cases of mutually exclusive projects, if the decision based on NPV versus IRR differs because of scale differences or cash flow timing differences, which decision rule is best?

Answer 1

NPV decision rule is always the best.

NPV accounts for the scale differences of the projects.

Eg. Project A Initial investment $100

Expected cash flow of $200

This has an IRR of 100%

and an NPV of $81.81 at 10% discount rate

Say Project B has an initial investment of $1 million and the expected cash flow of $1.2 million in one year.

This has an IRR of 20% and NPV of $90,909.

If the projects are mutually exclusive do you take Project A just because it has a higher IRR of 100% and get only $100 in one year? No! You take project B because it has a higher NPV.

Also, you cannot use IRR when there are multiple sign changes in the cash flows.

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