Conflicting NPV and IRR ranking

The ranking of alternative proposal and the decision regarding selection of a proposal on the basis of NPV and IRR may not always be same.

As long as the appropriate discount rate is used, the NPV technique will always provide the correct ranking,

It is the IRR technique, which may produce incorrect ranking while evaluating mutually exclusive proposals.

Reasons and conditions

Scale or size disparity among different alternative proposals:

A conflict in ranking can arise because of the size difference of different proposals.

The ranking of NPV technique, which deals with absolute net benefits, will be affected by the size of the proposals. Higher the cash outflow larger would be the expected returns in absolute terms

IRR deals with relative returns (i.e., in percentage form) and hence ignores the size of the proposal. For instance, if all the cash flows of a proposals are doubled, then the NPV will also double but its IRR would remain unchanged.

Different timing or Time Disparity among alternative proposals

The different ranking may occur as a result of different timing of the cash inflows of different proposals.

Situations where - Larger cash inflows from one proposal occur during early period of its lifetime while larger cash inflows from some other competitive proposal occur towards the end of economic life.

For example, the cash inflows from one proposal may increase over time, while those of others may decrease or remains constant over time.

Reinvestment Rate Assumption:

Assumption regarding the rate of compounding and discounting the intermediate cash flows.

In discounting techniques of evaluation of capital budgeting , there is an implied reinvestment rate assumption

This reinvestment rate is built into the present value factors (PVF and PVAF), which are used to find out the NPV and the IRR by adjusting the future cash inflows for time value of money.

It is assumed that when the cash inflows are received, they are immediately reinvested in another project or asset.

NPV technique assumes that all the intermediate cash inflows are reinvested at a rate equal to the discount rate i.e all the intermediate cash inflows are assumed to be reinvested at the same rate i.e. the discount rate regardless of which proposal is accepted.

The IRR technique assumes that the intermediate cash inflows are reinvested at a rate equal to the proposal's IRR itself thus; different alternative proposals will have different reinvestment rates.

The conflict in the ranking of mutually exclusive proposals as per the NPV and the IRR techniques arises as a result of different reinvestment rate assumptions of the two techniques acting in different ways on the proposals having time disparity of cash inflows.

In practice,

it may not be realistic to assume that the reinvestment rate of the firm will depend upon the proposal being accepted.

The reinvestment rate is fixed and being an external variable it has nothing .to do with the proposal being accepted or rejected.

The reinvestment rate assumption made by the IRR technique creates serious consequences.

It implicitly assumes that the firm has and will continue to have a series of projects where the cash inflows of the project under consideration would be reinvested yielding returns similar to that earned by the proposals under consideration.

Life disparity or proposals with unequal lives The mutually exclusive proposals may have different

economic lives and this should not affect the choice between them, even if the ranking as per NPV and the IRR are different.

The proposal with the higher NPV should be selected, as it will result in the higher increase in the wealth of the shareholder.

If the IRR technique is to be used then it must be verified with the incremental yield technique