Question

Discuss the following statement: If a firm has only independent projects, a constant WACC, and projects with normal cash flows, the NPV and IRR methods will always lead to identical capital budgeting decisions. What does this imply about the choice between IRR and NPV? If each of the assumptions were changed (one by one), how would you answer change?

Answer 1

If a firm has only independent projects NPV and IRR will lead to identical capital budgeting decisions for accepting a project NPV >0 and IRR > WACC will yield same result i.e. accept the project. If NPV <0 then IRR<WACC at the same time and project will be rejected. This implies that one can be indifferent with the choice of IRR and NPV for budgeting decisions. In NPV we assume that the cash is invested back at WACC but n IRR method the cash flow is assumed to be invested back at the rate of IRR. Since IRR is greater than WACC so it is realistic to assume that cash can be invested back at WACC rather than IRR. Hence NPV is better than IRR based upon our assumptions.

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