Question

Mr. Clotz, the president of Mega Enterprises, has to make a choice between two possible investments:

Project	C0	C1	C2	IRR (%)
A	-400	+250	+300	23
B	-200	+140	+179	36

The opportunity cost of capital is 9%. Mr. Clotz is tempted to take B, which has the higher IRR.

1. Explain to Mr. Clotz why this is not the correct procedure.
2. Show him .how to adapt the IRR rule to choose the best project.
3. Show him that this project also has the higher NPV

Answer 1

1. The decision taken by IRR rule may not always be correct due to the following reasons as it can have a conflicting issue with other capital budgeting techniques.

The NPV and IRR can lead to a conflicting decision because
1. The distribution of cash flow in the projects.
2. The size of the project.

NPV absolute measure whereas IRR is a relative measure.
NPV gives absolute dollar returns.
IRR are reinvest the cash flow at IRR rate, which is not true and hence not a better technique.

Npv is a better technique then compared to the internal rate of return.

2. IRR: It is the discount rate at which the present value of projects cash outflows (cost) is equal to the present value of projects cash inflow.

The IRR must be above the cost of capital/required rate of return.
To accept the project.

If the projects are mutually exclusive then the one with the highest internal rate of return will be preferred.

In this case, the first preference is given to project B, as it has a high IRR of 36% compared to project A (23%).

3. NPV = present value of cash inflow- the present value of cash outflow.

Discounted at the cost of capital/required rate of return. (9%)

NPV must be positive to accept the project.

If the projects are mutually exclusive then the project with the highest net present value will be preferred.

NPV of project A =
[250/(1.09)]+[300/(1.09)^2] -400.

NPV of project A = $81.86

NPV of project B =
[140/(1.09)]+[179/(1.09)^2] -200.

NPV of project A = $79.10

As per the net present value rule, project B must be accepted.