CONFLICT IN CASE OF RANKING

MUTUALLY EXCLUSIVE PROJECTS

CONFLICT IN CASE OF RANKING MUTUALLY EXCLUSIVE PROJECTS

NPV and IRR methods yield the same result in case of conventional independent projects. But in case of mutually exclusive projects IRR can be misleading. Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded. Under such situation, the more profitable out of two or more alternatives shall be selected. This type of exclusiveness is called technical exclusiveness.

CONFLICT IN CASE OF RANKING MUTUALLY EXCLUSIVE PROJECTS

Two independent projects may also be mutually exclusive if financial constraint is imposed. This is called. Financial exclusiveness or capital rationing.

CONFLICT IN CASE OF RANKING MUTUALLY EXCLUSIVE PROJECTS (cont..)

The NPV and IRR rules will give conflicting ranking under following circumstances The cash flow pattern of the projects may differ. The cash outlays of the project may differ. The projects may have different expected lives.

TIMING OF CASH FLOWS

The common reason for the conflict between IRR & NPV is the difference in the timing of cash flows.

Project

NPV @ IRR 9%

M N

-1680 -1680

1400 140

700 840

140 1510

301 321

23% 17%

NPV PROFILES OF M& N

DISCOUNT RATE( )

PROJECT M 56

PROJECT N 8 5 76 7 6 - 57

5 5 5

4 76 5 54 -4 5

- 88

TIMING OF CASH FLOWS



NPV of N falls rapidly as discount rate increases. Reason is this is its largest cash flows come late in life when compounding effect of time is more significant.

Scale of investment


 

NPV and IRR methods will give contradictory ranking when the cash outlays are of different sizes. Project As NPV is low. But IRR is high Project Bs NPV is high. But IRR is low.

PROJECT co S

c 5

NPV

IRR 5

A B

64

PROJECT LIFE SPAN



Difference in the life span of two mutually exclusive projects give rise of conflict between IRR and NPV.

Projec C t X -

C4

C5

NPV

IRR

4 5

FISHERS INTERSECTION
Fishers intersection occurs at the discount rate where NPVs of two projects are equal. NPVs of M & N intersect at discount rate. This is called Fishers intersection

NPV VS. IRRFISHERS INTERSECTION

NPV PROFILES OF PROJECTS M & N
1000 500 NPV 0 -500

Project M Project N

10

15

20

25

30

Project M 560 409 276 159 54 -40 -125 Project N 810 520 276 70 -106 -257 -388 DISCOUNT RATE (%)

Fishers intersection


The formula
n

(Ct)M/(1+r*)t (Co)M= n (Ct)N/(1+r*)t (Co)N

t=1

t=1

NPVM = NPVN

Fishers intersection


ILLUSTRATION determination of discount rate at which fishers intersection occurs

- 68 + 4

/( +r*) + 7

/( +r*) + 4 /( +r*)

- 68 + 4 /( +r*) +84 /( +r*) + 5 /( +r) Simplify - 6 /( +r*) + 4 /( +r*) + 5 /( +r*) = By trial & error, r* =

Fishers intersection
Discount rate ( ) Project M Project N

56 5 5 5 4 76 5 54 -4 5

8 5 76 7 6 - 57 - 88


At discount rate less than intersection rate ( ), Project N has more NPV but low IRR Greater than ,M has more NPV and higher IRR.

Fishers intersection
 

If r> r*- Consistent result If r<r* - Contradictory result. A project with higher NPV will have lower IRR & Vice Versa. It is better choose project with higher NPV.

MULTIPLE INTERNAL RATE OF RETURN

A serious short coming of the IRR method, when used to evaluate non-conventional investments, is that it can yield multiple Internal Rate of Return. Lorie and savage were first to point out that certain configurations of cash flow A necessary, but not sufficient condition for this occurrence is that the cash flow stream changes sign more than once.

Multiple IRR (cont.) The formula for finding IRR is : Ct - Co = 0 t=1 (1+r)t In case of conventional investment only one positive value for r exists. In case of non-conventional project, there is a possibility of multiple roots of r. NPV =
n

Multiple IRR (cont..)

Let us consider the following project: When we solve for the IRR we find two rates i.e.25% & 400%(NPV is zero at these rates) This is an example of Multiple IRR. Similarly, Let us see the this table and chart Year

Cash flow

-$ 6

-$

Project AYear

Cash flow s

- 75

MULTIPLE IRR

DUAL RATE OF RETURN

200 0 0 NPV -200 NPV -400 -600 -800 DISCOUNT RATE 50 100 150 200

Multiple IRR (cont..)

DUAL RATE OF RETURN
200 0 0 -200 NPV -400 -600 -800 DISCOUNT RATE 50 100 150 200

It is clear that Project A yields dual rate of return & 5 5  At these rates, NPV of the project is zero.  At zero rate of discount, the NPV is simply the difference of undiscounted cash flows.  NPV As discount rate increases, the negative NPV diminishes and becomes zero at 5


MULTIPLE IRR


The positive NPV increases as discount rate exceeds 5 , but after reaching maximum it starts decreasing and at 5 it again becomes zero. In case of projects having multiple changes in sign both lending borrowing are involved.

DUAL RATE OF RETURN

200 0 0 -200 NPV NPV -400 -600 -800 DISCOUNT RATE 50 100 150 200

Multiple IRR (cont..) Although reversal in signs is a necessary condition for multiple IRR, it is not sufficient for such an occurrence. The occurrence of multiple IRR also depends on the magnitude of cash flows. When there are multiple IRRs none of them will work satisfactorily. In such cases, an alternative method must be used. The simple alternative is to use NPV rule.