Capital Budgeting Essay

Chapter 3 - Research Methodology
     
PROJECT SIZE AND LIFE

There are reasons why the NPV and the IRR are sometimes in conflict:   the size and life of the project being studied are the most common ones.   A 10-year project with an initial investment of $100,000 can hardly be compared with a small 3-year project costing $10,000.   Actually, the large project could be thought of as ten small projects.   So if you insist on using the IRR and the NPV methods to compare a big, long-term project with a small, short-term project, don’t be surprised if you get different selection results.   (See the equivalent annual annuity discussed later for a good way to compare projects with unequal lives.)

DIFFERENT CASH FLOWS

Furthermore, even two projects of the same length may have different patterns of cash flow.   The cash flow of one project may continuously increase over time, while the cash flows of the other project may increase, decrease, stop, or become negative.   These two projects have completely different forms of cash flow, and if the discount rate is changed when using the NPV approach, the result will probably be different orders of ranking.   For example, at 10% the NPV of Project A may be higher than that of Project B.   As soon as you change the discount rate to 15%, Project B may be more attractive.

WHEN ARE THE NPV AND IRR RELIABLE?
Generally speaking, you can use and rely on both the NPV and the IRR if two conditions are met.   First, if projects are compared using the NPV, a discount rate that fairly reflects the risk of each project should be chosen.   There is no problem if two projects are discounted at two different rates because one project is riskier than the other.   Remember that the result of the NPV is as reliable as the discount rate that is chosen.   If the discount rate is unrealistic, the decision to accept or reject the project is baseless and unreliable.   Second, if the IRR method is used, the project must not be accepted only because...