Npv and Iff

F. (1) What is the underlying cause of ranking conflicts between NPV and IRR?

Answer: For projects with traditional cash flow patterns, the NPV profiles will cross only when one project have a greater vertical axis and a steeper slope than the other. A project’s vertical axis intercept basically depends upon (1) the size of the project and (2) the size and timing pattern of the cash flows—large projects, and ones with large distant cash flows, generally would be expected to have relatively high vertical axis intercepts. The slope of the NPV depends entirely on the timing pattern of the cash flows—long-term projects have more slanting NPV profiles than short-term ones. Thus, we can say that NPV profiles can cross in two cases: (1) when two projects which are not dependent upon each other differ in scale (or size) and (2) when the projects’ cash flows differ in span of the timing pattern of their cash flows.

(2) What is the reinvestment rate assumption, and how does it affect the NPV-versus-IRR conflict?

Answer: The main reason of ranking conflicts is the reinvestment rate assumption. All discounted cash flow methods are based on the assumption that cash flows can be reinvested at some rate, irrespective of the fact of what actually is done with those cash flows. Discounting is just opposite of compounding, as compounding assumes reinvestment, and so do discounting. NPV and IRR are both found by discounting, so they both are based on assumption of some discount rate. NPV calculation has an inherent assumption that cash flows can be reinvested at the project’s required rate of return, or cost of capital, while the IRR calculation assumes reinvestment at the IRR rate.

(3) Which method is the best? Why?

Answer: The decision of which one is better depends upon the fact which method provides better rate of reinvestment. Normally NPV method provides better assumption of rate of reinvestment because cash inflows and replaces the amount of outside...