Question

When the management team considers what projects to continue with, there are positive NPV projects and negative NPV projects. Based on the readings for this week, what are the differences between these two projects? What are some problems with the IRR methodology compared to the NPV methodology?

Answer 1

The management of a company should accept only the projects having positive NPV. NPV refers to the Net Present Value of future cash outflows and future cash inflows at the required rate of return.

For mutually exclusive projects, the management of a company should accept the project having maximum NPV.

Positive NPV projects mean that the present value of future inflows is higher than the cash outflows for respective projects, hence these should be selected. On the other hand, negative NPV projects mean that the present value of future inflows is lower than the cash outflows for respective projects, hence these should not be selected.

IRR is the rate of return where NPV = zero. For acceptability, we choose the project having higher IRR.

IRR has the following problems:

1. IRR will be ineffective in case of a project with a mixture of multiple positive and negative cash flows.

2. When the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible. If it is below, the project is considered not doable. If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value.

Also, IRR and NPV often give contradictory results, i.e. using NPV one might choose project A but using IRR, one might reject project A. In such cases, one should give preference to NPV and base the decision on NPV methodology.