(17 of 20) Ch.9 - IRR vs NPV approach when comparing 2 projects - YouTube

Next example, A and B, two projects, are mutually exclusive.

Which project should you accept and why?

What do we know for each project?

Project A would require spending $400 in year zero.

In year one, it will return $325, in year two, it will return $200.

We also know that the internal rate of return for project A is 22.17% which is also something

you can calculate yourself.

And at 10% discount rate, the net present value is $60.74.

For project B, cash flow zero is negative 500, cash flow in year one is 325, cash flow

in year two is 325 again, the IRR is 19.43% and the net present value at 10% discount

rate is $64.05.

So, the question again is which project should you accept and why?

Because A and B are mutually exclusive, it means we can only pick one project if both

look acceptable, right?

Now, we are given the IRR and we are given the net present value for each.

So, let's see which project would be picked based on the IRR criteria.

So based on the IRR rule, you can see that the IRR is higher for project A than for project

B, right, 22.17% is larger than 19.43%.

And so, for this reason, you can say that we make a higher return on our money, right,

for every dollar invested, right, for project A. And because in both cases you make a better

return than what's typical, which is 10% per year, technically both are good projects but

because they are mutually exclusive, we need to pick the one that's better and that's project

A. You can also say that project A is the winner because it has a wider range of acceptable

required returns.

Now, let's look at which one we would choose based on the net present value rule.

So, both net present values are above zero, making both projects acceptable except we

need to pick one because they are mutually exclusive.

So, which one is better?

The one with a higher net present value is better, and that's project B, right?

Project B will generate an overall profit of $64.5 and project A will only generate

a profit of $60.74.

So based on the IRR rule, project A is the winner.

Based on the NPV rule, project B is the winner.

So, what do we do?

The two approaches sort of contradict each other, right, when we are applying them to

comparing to competing projects.

And in this case, you should always go with the net present value approach, with the recommendation

that the net present value technique provides.

And this was also the case on the earlier slides in this chapter when we would try using

the net present value approach and one more approach, let's say, the profitability index

approach or the payback period approach.

And in all those cases, we would always conclude that when in doubt, when there is a conflict

between the NPV approach and one other approach, then always go with the NPV approach.

Why?

Because that's the approach that tells you exactly how much cash you will get as a profit.

So, to conclude this [inaudible] for example, project B with a higher NPV should be the

winner.

Now, let's look at the same exact problem but we are only changing the wording slightly.

A and B are no longer mutually exclusive, they are now independent.

What does independence mean?

It means if both projects happen to be acceptable, we will accept them both.

Again, let's make our decision based on the IRR criteria.

The IRR rule says a project should be accepted if the required return, which is 10% in this

problem, is less than the IRR and both IRRs are above 10%, which makes both projects A

and B acceptable.

And because they are independent, we are independently making our decision regarding each project.

So, we are going to choose them both, both A and B. Now, the net present value rule,

what does the rule say?

A project should be accepted if the net present value is above zero dollars, right?

Is it?

Yes, $60.74 for project A, that's above zero dollars, and for project B, the NPV is $64.05,

again, a positive number.

So once again, if we make our decision on each project independently, we would be accepting

both A and B. So here, we didn't have any sort of contradiction between the two approaches.

They agree and it's going to be a clear decision to make.

We're going to accept both projects in this situation.