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Conflict Between NPV and Irr

there are always conflict between Net Present values and Internal Rate of Return..here are four scenario

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Petey K. Ndichu
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2K views3 pages

Conflict Between NPV and Irr

there are always conflict between Net Present values and Internal Rate of Return..here are four scenario

Uploaded by

Petey K. Ndichu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CONFLICT BETWEEN NPV AND IRR

The conflict between NPV and IRR occurs under the following circumstances

a) In case of non- conventional cash flows


b) In case of the disparity in sizes of the mutually exclusive project
c) In case of disparity in the timing of the cash flows of the mutually exclusive projects]
d) In case of disparity in the economic life of mutually exclusive projects.

i. In case of non-conventional cash flows.

Non conventional cash flows of a project are those cash flows which keep on changing from
positive to negative during the economic life of the project e.g. positive cash flows in year 1
followed by negative cash flows in year 2 due to the overhaul cost.

Example

XYZ limited has a two year project whose initial cash outlay is Shs. 1,000,000. The project
is expected to generate the following cash flows.

Year 1 2
Cash flows Shs “000” 4,000 (3,750)
Calculate the IRR for this project.

In case of non conventional cash flows IRR will give multiple rate of return for the same
project. In this case the NPV technique should be used to evaluate the project. The multiple
rates of return in case of non conventional cash flows can be summarised as shown below.

Fig1

ii. In case of disparity in size of mutually exclusive project

In this ease both NPV and IRR technique will give conflicting results when the initial cash
flow of mutually exclusive project is significant different.

Example

A company has mutually exclusive project with the following characteristics

Characteristics Project A Project B


Initial Cash outlay(Shs) 100,000 1,000,000
Economic Life 1 year 1 year
Annual Cash inflows 150,000 1,200,000
Cost of Capital 10 % 10 %
Compute the NPV and IRR of the two projects and rank them.

Soln:

The cause of the conflict between the NPV technique and IRR technique is because of the
size of the projects. In such cases the profitability index is used to evaluate the mutually
exclusive projects.

iii. In case of disparity in the timing of the cash flows of the mutually exclusive
projects

This is where the cash flows of mutually exclusive projects differ, where one project
promises an annuity cash flow, while the other project promises non annuity cash flows.
Therefore the difference in ranking this mutually exclusive project will be caused the
assumption that the cash flows from this project are re-invested at a particular rate of
return.

Example

A company has 2 mutually exclusive projects A & B which have the following characteristics

A B
Initial cash flows (Shs) 50,000 50,000
Economic life 4 years 4 years
Cost of Capital 10 % 10%
Cash Flows 21,172 0
21,172 10,590
21,172 21,172
21,172 69,180
Required: compute NPV and IRR for the two projects and then rank them

Soln

In such cases the profitability index should be used.

iv. In case of disparity in the economic life of mutually exclusive projects

Where mutually exclusive projects have a different economic life then the NPV and IRR will
give conflicting results. However in this instance the NPV technique will prevail. The NPV
technique will be adjusted to obtain the replicated NPV. The replicated NPV is the NPV of a
project, assuming the project is replaced with a similar project each time its economic life
comes to an end until perpetuity.

Examples:

Consider project A&B which are mutually exclusive projects with the following
Characteristics.
A B
Initial Outlay (Shs) 1,000,000 1,000,000
Annual Cash flows(Shs) 500,000 300,000
Economic Life 3 years 6 years
Cost of Capital 10% 10%

Required: compute NPV and IRR for the two projects and then rank them

Soln.

In this case use replicated NPV

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