CP

(2) IRRSexceeds IRRL. Therefore, if r is greaterthan the crossover rate of 7.2 percent,

the two methods both lead to the selection of Project S. However, if the cost of capi-

tal is less thanthe crossover rate, the NPV method ranks Project L higher, but the IRR

method indicates that Project S is better. Thus, a conflict exists if the cost of capital is less

than the crossover rate.^8 NPV says choose mutually exclusive L, while IRR says take S.

Which is correct? Logic suggests that the NPV method is better, because it selects the

project that adds the most to shareholder wealth. But what causes the conflicting rec-

ommendations?

Two basic conditions can cause NPV profiles to cross, and thus conflicts to arise

between NPV and IRR: (1) whenproject size (or scale) differencesexist, meaning that the

Comparison of the NPV and IRR Methods 271

FIGURE 7-4 Net Present Value Profiles: NPVs of Projects S and L

at Different Costs of Capital

Cost of Capital NPVS NPVL

0% $300.00 $400.00

5 180.42 206.50

10 78.82 49.18

15 (8.33) (80.14)

Net Present Value

($)

Crossover Rate = 7.2%

5 10 Cost of Capital (%)

15

0

400

300

200

100

–100

Project L's Net Present Value Profile

Project S's Net Present Value Profile

IRR = 11.8%L

IRRS = 14.5%

7.2

See Ch 07 Tool Kit.xls.

(^8) The crossover rate is easy to calculate. Simply go back to Figure 7-1, where we set forth the two projects’
cash flows, and calculate the difference in those flows in each year. The differences are CFS
CFL$0,
$400, $100,
$100, and
$500, respectively. Enter these values in the cash flow register of a financial
calculator, press the IRR button, and the crossover rate, 7.17%
7.2%, appears. Be sure to enter CF 0  0
or else you will not get the correct answer.

The Basics of Capital Budgeting: Evaluating Cash Flows 269