Question

When two mutually exclusive projects are being compared, explain why the short-term project might be ranked higher under the NPV criterion if the cost of capital is high whereas the long-term project might be deemed better if the cost of capital is low. Would changes in the cost of capital ever cause a change in the IRR ranking of two such projects? Why or why not?

Answer 1

Because of crossover rate, NPV profile is different for the two projects. Long-term projects have more sensitivity to changes in cost of capital compared to short- term project. Hence, short-term project may have higher rank under NPV criterion if cost of capital is high. But if cost of capital is low, long -term project will be ranked higher because sum of all cash flows of long term project would be more than short term project.

Yes change in cost of capital causes change in IRR ranking of such projects. One project might have greater IRR and lesser NPV when cost of capitlal is lower than the crossover rate and the other project vice versa