Question

11. IRR rule Mr. Cyrus Clops, the president of Giant Enterprises, has to make a choice between two possible investments: Cash flows ($ thousands) Project CoC C IRR(%) A -400 +250 +300 23 B -200 +140 +179 .36 The opportunity cost of capital is 9%. Mr. Clops is tempted to take B, which has the higher IRR. a. Explain to Mr. Clops why this is not the correct procedure. b. Show him how to adapt the IRR rule to choose the best project. c. Show him that this project also has the higher NPV.

Answer 1

a.IRR is the not best procedure to evaluate projects as it fails to recognize size of project and it provides conflicting results with the best method (NPV) .IT assumes that cash flows will be reinvested at IRR which is not always possible.

b. Instead of IRR for discounting using cost of capital for discounting can provide better results. Using Discount rate of 9% provides that Project BA provides higher NPV

c. NPV of Project A =-400+250/1.09+300/1.09^2 =81.86
NPV of Project B =-200+140/1.09+179/1.09^2 =79.10

NPV of Project A is higher