Just looks basic but i need to ask… schwesser book says about NPV “Its main weakness is that it does not include any consideration of the size of the project.” page 22 book 4 but i think this is the problem with IRR method and not NPV method. because IRR method does not consider whether the project size in $100 or $10000000. On the other hand NPV gives you the increase in firm value. greater the size of project, greater NPV, greater firm value increase can anybody help?
Schweser is correct. If the firm faces capital rationning, it might be forced to abandon too big sized projects, even if NPV is higher. On the other hand, IRR gives you a rate of return on the project so it would be a somewhat index of profitability of the project. However, NPV rule is still preferrable since even when faced with capital rationning you would choose the project with the greates NPV that you can finance.
Agreed. You always chose the higher NPV when comparing projects. The only issue is when two mutually exclusive projects give conflicting results, where the high NPV is associated with the small IRR project. This is not an NPV conflict, it is an IRR conflict (important to know that). In such a case, you will find that the small IRR project will be the preferred project only when the cost of capital is less than the cross over rate (the rate at which the NPV’s are equal). So check your understanding: Assume IRR_1 < IRR_2, for two mutually exclusive projects. 1) If cost of capital > both IRR_1 and IRR_2, would there be an IRR conflict? 2) If cost of capital > both IRR_1 and less than IRR_2, would there be an IRR conflict? 3) If two projects are independent, would there be an IRR conflict?
Thanks Dreary: I think 1) choose no project 2) IRR-2 3) no chance of conflict bcoz separate decision but i have seen this question of NPV couple of times and I am confused what should be the answer for this type of question. whether IRR/ NPV account for the size of project or not?
the reason NPV doesn’t account for the size of the project is because it weights cash flows. lets say you have a 1,000$ project, that expects cash flows with a present value of 1,100$. this means an NPV of 100. Now lets say you have a 1,000,000$ project. this has expected cash flows with a present value of 1,000,100$. This one also has an NPV of 100. Which one are you going to choose? Thats why NPV doesnt account for project size.
Dreary, that was genius at work.
so it means none of the capital ting technique accounts for the size of project?
That’s good Lloyd. It’s a little confusing, because it sounds as if IRR takes care of the size problem! Because we are always comparing the two, but I guess on its own yes NPV doesn’t reveal anything about size, neither IRR.