IRR NPV

CFA Level II
#1

If we are evaluating mututally exclusive projects with conventional cash flows and same investment outlays can we not use the IRR or NPV?

CFA EOC says only the NPV must be used as a short term project with high IRR can have low NPV than long term project. If this is the case when is it acceptable to use the IRR? I guess in any comparison its NPV over IRR? Or is there some situations where we can base on IRR alone? Basic L1 question i know… lol

#2

Mutually exclusive you MUST use NPVs - IRRs can give you opposing decisions.

Only if they are not mutually exclusive will they give you the same accept/reject decions. If NPV is positive your IRR will be above the cost of capital and you can accept; and since the projects are not mutually exclusive you can use this logic for all projects.

I typically just use NPV - it’s theoretically justified and the test generally wants you to err on that side.

#3

You can use IRR to decide yes/no on a single project.

Apart from that, NPV’s better.

#4

OK great thanks both

#5

You’re welcome.

#6

Hi,

If you have capital rationing constraints, you would tend to use IRR. Small, high growth companies and private companies are much likely to use iRR as they have limited access to capital and faces more uncertainty in its project cash flows. On the other hand, If a business has substantial funds on hand, access to capital, limited surplus value projects, and more certainty on its project cash flows, it is much more likely to use NPV as its decision rule.

You can consider the following Mutually exclusive example:

  1. Investment in time 0 = 1000000, 1 = 350,000 2=450,000 3=600000 4=750000

NPV = 467937, IRR=33.66%

  1. Investment in time 0 =10,000000 1=3M 2= 3.5M 3=4.5M 4= 4.5 M

NPV = 1358664, IRR=20.88%

IRR as a percent is biased towards smaller investments.

In an ideal world, we believe that all companies would be able to raise capital. In the case I choose option 2 and I have max 10 M to spend, and I use my decision to choose Project 2, and IF I encounter another great projects, I wont be able to take it unless I am able to raise capital easily. If there are capital rationing constraints, companies will prefer using IRR

In any case, using NPV as a decision rule is fine with the info we have in the curriculum

#7

Thanks Saurabm!