Question

6. Understanding the NPV profile 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 Y and Z are mutually exclusive projects. Their cash flows and NPV profiles are shown as follows. Year Project Y Project Z 0 –$1,500 –$1,500 1 $200 $900 2 $400 $600 3 $600 $300 4 $1,000 $200 If the weighted average cost of capital (WACC) for each project is 2%, do the NPV and IRR methods agree or conflict? The methods agree. The methods conflict. A key to resolving this conflict is the assumed reinvestment rate. The IRR calculation assumes that intermediate cash flows are reinvested at the , and the NPV calculation implicitly assumes that the rate at which cash flows can be reinvested is the . As a result, when evaluating mutually exclusive projects, the is usually the better decision criterion.

Answer 1

If the crossover rate on the NPV profile is below the horizontal axis, the methods will always agree.

The methods conflict.

The IRR calculation assumes that intermediate cash flows are reinvested at the Internal Rate of Return (IRR), and the NPV calculation implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital (WACC) or required return.

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