If an independent project with conventional, or normal, cash flows is being anal
ID: 2651713 • Letter: I
Question
If an independent project with conventional, or normal, cash flows is being analyzed, the net present value (NPV) and internal rate of return (IRR) methods agree. Projects W and X are mutually exclusive projects. Their cash flows and NPV profiles are shown as follows. If the weighted average cost of capital (WACC) for each project is 14%, do the NPV and IRR methods agree or conflict? The methods agree. The methods conflict. A key to resolving this conflict is the assumed reinvestment rate. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at the , and the IRR calculation assumes that the rate at which cash flows can be reinvested is the As a result, when evaluating mutually exclusive projects, the is usually the better decision criterion.Explanation / Answer
Answer:
1. If an independent project with Conventional, or normal, cash flows is being analyzed , the NPV and IRR methods generally agree.
2. Calculation of NPV and IRR for the Projects:
Year
PVF (14%)
Project W
Project X
CF(w)
CF(w) *PVF
CF(x)
CF(x) *PVF
0
1.00000
-1000
$ (1,000.00)
-1500
$ 1,500.00
1
0.87719
200
$ 175.44
350
$ (307.02)
2
0.76947
350
$ 269.31
500
$ (384.73)
3
0.67497
400
$ 269.99
600
$ (404.98)
4
0.59208
600
$ 355.25
750
$ (444.06)
Net Present value
$ 69.99
$ (40.79)
Year
Project W
Project X
0
-1000
-1500
1
200
350
2
350
500
3
400
600
4
600
750
IRR =
16.85%
15.17%
As per NPV evaluation only Project W can be accepted as it has positive NPV.
But as per IRR evaluation both projects can be accepted as they have IRR more than the WACC.
Hence There is a Confliction between both methods.
3. NPV assumes that intermediate cash flows are reinvested at discount rate , and IRR assumes that the rate at which cash flows can be reinvested is the IRR.
4. As a result when evaluating mutually excusive projects , the NPV is usually the better decision criteria.
Year
PVF (14%)
Project W
Project X
CF(w)
CF(w) *PVF
CF(x)
CF(x) *PVF
0
1.00000
-1000
$ (1,000.00)
-1500
$ 1,500.00
1
0.87719
200
$ 175.44
350
$ (307.02)
2
0.76947
350
$ 269.31
500
$ (384.73)
3
0.67497
400
$ 269.99
600
$ (404.98)
4
0.59208
600
$ 355.25
750
$ (444.06)
Net Present value
$ 69.99
$ (40.79)
Year
Project W
Project X
0
-1000
-1500
1
200
350
2
350
500
3
400
600
4
600
750
IRR =
16.85%
15.17%