Question

1a. Why might a financial analyst use the NPV method for making project decisions instead of the IRR method?

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1b. Explain the reinvestment rate assumption in the context of a project’s cash flows over time.

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1c. When we create NPV profiles, what variable is on the y-axis and what variable is on the x-axis?

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1d. Suppose a firm’s WACC exceeds the IRR for both projects L and S, if the projects are mutually exclusive, which project should the firm invest in? What if the projects are not mutually exclusive, then which project(s) should the firm invest in? (Hint: If the WACC is greater than both projects’ IRR, then both projects would delivery negative NPV.)

Answer 1

1a)	The NPV of a project represents the absolute addition to shareholders' wealth
	if, the project is implemented. Thus one is able to gauge how far the project
	is able to satisfy the financial goal of 'increasing the shareholders' wealth',
	if implemented.
	Further, when there are alternative projects, the NPV can be used to rank the
	projects appropriately by giving Rank 1 to the project having the highest NPV
	and then ranking the others in the descending order of NPV. This ensures that
	Projects that maximize shareholders' wealth are given preference, subject
	of course to availability of funds.
	The IRR on the other hand is the rate of return that the cash flows of a project
	afford. It gives the same accept/reject decision as NPV by accepting projects
	with IRR>WACC and rejecting others.
	But, while ranking, the IRR would give different rankings as it is a rate and not
	an absolute figure. Going by the IRR rankings, one might end up selecting
	projects that do not make the maximum addition to shareholders' wealth.
	This is so because the project that gives maximum NPV may have the lowest
	IRR.
	Further, a project can hace multiple IRRs in certain situations.
	Hence, a financial analyst may prefer the NPV method over the IRR.
1b)	This relates to the assumption as to the rate for reinvestment of intermediate
	cash flows of a project; that is the rate at which it is possible to reinvest the
	cash inflows of the project once it is implemented. This reinvestment rate will
	decide the relative worth of the projects.
	While the NPV assumes that the reinvestment rate for all the projects is the
	WACC, the IRR assumes that the reinvestment rate for each project is its own
	IRR. This, on some occasions, results in conflicting ranking of alternative projects
	by the NPV and IRR methods.
	Though WACC as the reinvestment rate is acceptable, the reinvestment rate
	where the project has high IRR is not acceptable.
	To resolve this situation, while using the IRR technique, the MIRR, which assumes
	that WACC is the reinvestment rate, can be used.
1c)	For the NPV profite, the NPV is on the y-axis and the cost of capital on x-axis.
1d)	In both cases the Projects should be rejected as their IRR is less than WACC. The resons is that.
	projects with IRR<WACC will result in negative NPV thereby eroding shareolders'
	wealth.