Chapter 4 • Investment appraisal methods
Figure 4.1 below. The graph is close enough to being a straight line for this not to be
important, however.
Where IRR is used to assess projects, the decision rule is that only those with an IRR
above a predetermined hurdle rate are accepted. Where projects are competing, the
project with the higher IRR is selected.
The IRR approach so closely resembles the NPV method that at first glance it
appears that they are completely interchangeable. This might lead us to assume that
they will always come to similar conclusions on any particular decision. This is not
true, as can be seen by the following comparison of methods.Comparison of IRR and NPV methods
l IRR is notdirectly related to the wealth maximisation criterion. If the hurdle rate
used in conjunction with IRR is the cost of borrowing then in most cases the two
methods will give identical results. Certainly this will tend to be the case on
straightforward accept/reject decisions (that is, those where the decision is either to
invest or not to invest). With competing projects the two methods sometimes give
conflicting signals. This can happen where two mutually exclusive projects involve
a different scale of investment.Two mutually exclusive projects have the following features:Cash flows
Year Project A Project B
££
0 (10,000) (6,000)
1 6,000 3,650
2 6,000 3,650
NPV @ 10% 413 334
IRR (approximately) 13% 14%If the cost of finance to support the project is 10 per cent p.a., which of these two pro-
jects should the business pursue (assuming no shortage of finance)?Example 4.4There is obviously a conflict here. Both NPV and IRR are based on discounting cash flows. Both
Projects A and B have IRRs in excess of 10 per cent, and yet there are different signals coming
from the NPVs and the IRRs. Figure 4.1 shows a graph of NPV against discount rate for these
two projects. Not surprisingly, as the discount rate is increased the NPV falls. The points
where the curves cross the horizontal axis are the respective IRRs for each of the projects.
It is possible to read off, for each project, the NPV for any particular discount rate. For
example, at an 8 per cent discount rate the NPV for Project A is about £700 and for Project
B about £500. At discount rates up to about 11.3 per cent Project A has the higher NPV.
Beyond 11.3 per cent, Project B has the higher NPV.
Going back to the question as to which project should be selected, the correct answer
(from a wealth maximisation viewpoint) is Project A. Although Project B would be more
attractive if the cost of finance were over 11.3 per cent, the fact of the matter is that here it
is 10 per cent, and since the business is pursuing wealth maximisation, Project A is the one
that should be selected. The conflict arises because of an incorrect implicit assumption
made by those who use the IRR method. The discount rate used with NPV should be theSolution