Comparing net present value and internal rate of return analysis
A) is only necessary on mutually exclusive projects.
B) may give different accept/reject decisions.
C) always results in the same accept/reject decision.
D) always results in the same ranking of projects.

Question

Quizplus · Accepted Answer

Net present value (NPV) and internal rate of return (IRR) analysis are two widely used methods to evaluate the profitability of investment projects. While both methods take the time value of money into consideration, they differ in the way they discount cash flows and in the information they provide. Specifically, NPV calculates the present value of all cash inflows and outflows of a project using a predetermined hurdle rate as the discount rate. A positive NPV indicates that the project is expected to generate more cash than it costs and is therefore considered acceptable. On the other hand, IRR is the discount rate that makes the NPV of a project equal to zero. In other words, it is the rate of return that the project is expected to earn on the invested capital. A project is acceptable if its IRR is higher than the hurdle rate.

While both NPV and IRR provide valuable information about a project's profitability, they may lead to different accept/reject decisions because they consider different aspects of the project. For example, NPV assumes that cash flows are reinvested at the discount rate, while IRR assumes that they are reinvested at the IRR itself. Moreover, IRR may give multiple solutions, making it difficult to interpret. Therefore, it is important for firms to use both methods together and to compare the results to make a well-informed investment decision. However, it should be noted that the comparison between NPV and IRR is only necessary when evaluating mutually exclusive projects, i.e., when choosing between projects that have similar objectives and cannot be pursued simultaneously.

Comparing Net Present Value and Internal Rate of Return Analysis