CONFLICT BETWEEN NPV AND IRR IN MUTUALLY EXCLUSIVE

PROJECTS

Capital decisions for independent projects are straightforward:

When IRR > K , NPV > O

When IRR < K , NPV < O

Therefore, both decision depends on K or discount rate.

But if we’ve mutually exclusive investment, then we may have a conflicting decision
problem. Since we will pick project with the highest NPV or IRR (it’ll not occur in
an independent investment decision), conflicting decision may occur. For example,

If NPVa > NPVb then choose a.

However, IRRa < IRRb we should choose b.
A conflict between NPV and IRR has just occurred.

Three effects that can result in conflicting decisions are scale, timing, and horizon
problem.

1. Scale Problem

An Example:
0 1 2 3
X (2000) 1010 1010 1010
Y (110,000) 50,000 50,000 50,000

K = 10%
Note: They have tremendously different costs.

NPVx = 512 IRRx = 24%

NPVy = 14,350 IRRy = 17.3

Since NPVy > NPVx , choose y

But IRRx > IRRy, choose x
Results: Conflict!!
Figure 1: NPV Profile
The K of 17.1% is the point of indifference where their NPVs are equal.

If K < 17.1%, choose Y since it has higher NPV than X.

If K > 17.1%, choose X since it has higher NPV than Y

In our example above, we have designated K = 10%, we should choose Y.

However, there is a need to resolve this conflict in an easier way by using the
Profitability Index (PI) approach. The PI approach gets rid of a scale problem by
“standardizing” the size of a project. It achieves this feat through the ratio between
present value of benefits (PVCF) to the cost of the project, unlike the NPV approach
where it looks at the difference between the two variables.

Method: ΣPIcombination = Σ (% allocation of bigger project) (PI)

Where, for each project, PI = PVCF / Cost

One assumption: Excess fund not invested will be assumed to have PI = 1

Using the above example:

X
PVCF = 2512, cost = 2000, NPVx = 512

Y
PVCF = 124,350, cost = 110,000, NPVy = 14,350,
Given: Excess fund not invested will be assumed to have PI = 1, and
PI = PVCF/ COST for each project.

DECISION RULE: CHOOSE THE HIGHEST ΣPIcombination

PIx = 2512/ 2000 = 1.256

PIy = 124,350/ 110,000 = 1.1305

Σ PIx = 2,000 (1.256) + 108,000 (1)

110,000 110,000

= .0228 + .9818 = 1.0047

Σ PIy = 110,000 (1.1305) = 1.1305

110,000

Therefore, project Y is better.

Note: The outcome from the PI approach now agrees with that of the NPV.

2. Timing effect.

This problem occurs when comparable projects have different timings of cash flows.

For example:

0 1 2 3
i.e. P (1200) 1000 500 100
Q (1200) 100 600 1100

K = 10%
NPVp = 197 IRRp = 23%
NPVq = 213 IRRq = 17%

Depending on which method used, either P or Q appears to be chosen.

Why the discrepancy?

Because IRR assumes the investment at IRR, and NPV assumes reinvestment
at cost of capital

Two problems with the IRR assumption

a) Is IRR a realistic rate of investment?

For example, is IRR of 23% of Q realistic for reinvestment? K may be more
realistic. In the long run, the re-investment rate approached at the cost of capital or
K

b) Lack of comparability
Because of (a), therefore, it is difficult to compare 23% reinvestment rate to 17%.

The way to solve this problem is to use the MODIFIED IRR.

To adjust or modify an IRR:

We have to compute terminal value (TV) artificially, at the realistic rate, by

holding that rate between the two projects at a level normally at a cost of capital, at
K = 10%

i.e.
TVp = 1000 (1.10) + 500 (1.10) + 100 = $1860
TVq = 100 (1.10) + 600 (1.10) + 1100 = $1881

This way makes the two projects comparable at a common reinvestment rate, at the
cost of capital of 10% in this example.

IRRp* = 1860 - 1200 = 0

(1+i)3
*modified IRR

Therefore, iP = 15.72%

IRRQ* = 1881 - 1200 = 0

(1+i)3
iQ = 16.16%

Therefore CHOOSE Q.

NOTE: the modified IRR gives the same decision as NPV (namely choose Q).

3. Horizon Problem

This problem occurs when one investment has a longer life.

i.e. 0 1 2 3
x (1000) 1500 - - (1yr life)
y (1000) - - 2000 (3yr life)

K= 10%
NPVx = 363 IRRx = 50%
NPVy = 502 IRRy = 26%

Again, depending on what method used, either X or Y may be chosen.

To solve this problem, two possibilities have to be considered first:

a) Never invest in another one again not too realistic, or
b) Keep buying them

If assumption (a) is correct, then it reduces to a timing problem

If assumption (b) is correct, then a replacement chain must be set up.

i.e. Do a replacement chain for project X to make it equal to 3 years as in project Y.

0 1 2 3
(1000) 1500
(1000) 1500
_____ _____ (1000) 1500
(1000) 500 500 1500

NOTE: Now we have the same life for both X and Y.

NPVX* = 995
NPVy = 502 (Note: we don't have to adjust for Y here, because it already has a
3-year life)

* Using a replacement chain.

Therefore, choose X.

A replacement chain uses Lowest Common Denominator (LCD) to calculate a

number of possible permutations.

i.e. When there is a large permutation , say, between a 11-year and a 12-year life
projects, the permutation is too cumbersome:

LCD = 11 x 12 = 132 yrs --------UNREALISTIC!

For the BEST alternative, we use the "uniform annuity series" or UAS method.
A.K.A Equivalent Annual Econ Profit (EAEP)

UAS = NPV / PVIFA

Essentially, NPV is expressed as “NPV per period.”

Decision rule: choose highest UAS.

 363
 1 
1  (1.10) 
UASX =   = 399
 .10 

 


502
 1 
1  3 
UASY =  (1.10)  = 201.85
 .10 
 
 
 

Choose X because UAS for x of $399 is the highest.

From a cash flow standpoint, UAS is equivalent to:

0 1 2 3 K = 10%

X (1000) 1500
0 399
Both cash flow streams have NPVx = 363

Y (1000) - - 2000
0 201.85 201.85 201.85
Both cash flow streams have NPVy = 502

This is a weakness using UAS approach because it assumes that there are no
changes in the cash flow structures, for example, no increase in cost or other
inflation factor.

Essentially, the UAS method assumes that a project will be replaced indefinitely:

Assumption: the PV of project X to be replaced forever . The value of these

projects can be stated, using the perpetual equation, as followed:

PV = Cash Flow / Interest Rate

PVx = 399 / 0.10 = $3,990

PVY = 201.85 / 0.10 = $2,018.50

Again, it clearly shows that project X is superior to Y.