Net Present Value (NPV) and Internal Rate of Return (IRR) methods yield conflicting outcomes due to _____.

(A) Unconventional cash flows

(B) Investment size disparity

(C) Investment life disparity

(D) Cash flow pattern disparity

Choose the most appropriate answer from the options given below:

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

The internal rate of return is a metric used in financial analysis to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. IRR is the annual rate of growth investment is expected to generate. IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates of annual return over time.

Conflicts Between NPV vs IRR:

In the case of mutually exclusive projects that are competing such that acceptance of either blocks acceptance of the remaining one, NPV and IRR often give contradicting results. NPV may lead the project manager or the engineer to accept one project proposal while the internal rate of return may show the other as the most favorable. Such a kind of conflict arises due to a number of problems.

1. For one, conflicting results arise because of substantial differences in the amount of capital outlay of the project proposals under evaluation.
2. Sometimes, the conflict arises due to issues of differences in cash flow timing and patterns of the project proposals or differences in the expected service period of the proposed projects.
3. When faced with difficult situations and a choice must be made between two competing projects, it is best to choose a project with a larger positive net value by using a cutoff rate or a fitting cost of capital.
4. The reason the two above-mentioned options works is because a company’s objective is maximizing its shareholder’s wealth, and the best way to do that is choosing a project that comes with the highest net present value. Such a project exerts a positive effect on the price of shares and the wealth of shareholders.
5. So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive. Actually, NPV is considered the best criterion when ranking investments.

Thus, option 4 is the correct answer.