Statement 1: For a single project, the IRR and NPV rules lead to exactly the same accept/reject decision. If the IRR is greater than the required rate of return, the NPV is +ve, and if the IRR is less than the required rate of return, the NPV is -ve. Statement 2: Given that shareholder wealth maximization is the ultimate goal of the firm, always select the project with the greatest NPV when the IRR and NPV rules provide conflicting decisions. Considering the above two statements (as per CFA curriculum) is it safe to say that to determine the acceptability of mutually exclusive projects we should use NPV? Since, +ve NPV will definitely mean IRR is greater than required rate of return. -babaji
Yup. Always use NPV to make the decision when it’s available. you’re also correct that +ve NPV will definitely mean IRR is greater than required rate of return.
NPV is preferable, because sometimes you might just have no IRR or several solutions for it. The latter is the case when the signs of cash flows change more than once (that is if there are additional cash outflows to the initial investment).
There’s a fundamental difference between deciding on independent projects and deciding BETWEEN mutually exclusive projects. In the first case, you make a GO/NO Go decision on the first project, and if the NPV is positive (or the IRR > reguired rate), accept it. THen do likewise for the second. You can use either in this case as long as they’re both “normal” projects (i.e. cash outflows followed by cash inflows). In this case, there’s a 1 to one correspondence between the two measures (i.e. if the NPV rule says accept, so will the IRR rule). And all you care about is whether each project is “good”. So, either rule works. In contrast, with mutually exclusive projects, you care which is “better”. It’s possible that you could have project A with a higher IRR and Project B with the higher NPV (look in your text for the concept of “Crossover Rate”. NPV translates directly to shareholder wealthj - since the shareholders hold the residual claim, and increase in economic value over and above financing costs accrues to them. However, a higher IRR need not imply a higher NPV - in particular because IRR doesn’t account for the scale of the project and for the slope of the NPV profile. Just remember - the goal of the firm should be to maximize shareholder wealth, so the “best” measure should be denominated in $$(you can’t spend a % return, only $$). Since NPV is denominated in $$ (i.e. wealth), if you have to choose between higher % return (i.e. IRR) and higher $$ (i.e. NPV), go with higher $$.
Thanks everyone. Thanks “busprof” for a wonderful explanation.