"NPV and IRR methods result in conflicts only if mutually exclusive projects. What do you consider mutually exclusive projects and how would you rank these projects?"
http://en.wikipedia.org/wiki/Net_present_value
http://en.wikipedia.org/wiki/Internal_rate_of_return
Mutually exclusive projects are projects that cannot be undertaken simultaneously due to limited resources, conflicting requirements, or other constraints. In the context of investment decisions, mutually exclusive projects refer to projects that, if one is accepted, the others must be rejected.
To rank mutually exclusive projects, you can consider several criteria:
1. Net Present Value (NPV): NPV is the difference between the present value of cash inflows and the present value of cash outflows over a given time period. It helps determine the profitability and value of a project. The higher the NPV, the more favorable the project.
2. Internal Rate of Return (IRR): IRR is the discount rate at which the present value of cash inflows equals the present value of cash outflows. It represents the project's rate of return. The higher the IRR, the more attractive the project.
When considering NPV and IRR methods for ranking mutually exclusive projects, conflicts may arise due to different outcomes. Here's how:
1. Conflicts in Ranking: NPV and IRR may lead to different rankings for mutually exclusive projects. This occurs when the projects have different cash flow patterns, sizes, or durations. NPV ranks projects based on dollar value, while IRR ranks projects based on percentage return.
2. Multiple IRRs: If a project has non-conventional cash flows (e.g., initial cash outflows followed by multiple cash inflows), it may lead to multiple IRRs or even no real solution. This can complicate the ranking process compared to using NPV.
To resolve conflicts and rank mutually exclusive projects:
1. Consider NPV as the primary criteria for ranking. It focuses on the absolute value of the project's profitability.
2. Use IRR as a secondary criterion to assess the project's internal rate of return. It provides insight into the project's efficiency and attractiveness.
3. Look for consistency between NPV and IRR rankings. If both methods consistently rank projects similarly, it provides more confidence in the decision-making process.
It's important to note that while NPV and IRR are widely used evaluation methods, they have their limitations. They rely on assumptions such as accurate cash flow estimates, a constant discount rate, and the ability to reinvest cash inflows at the calculated rate of return.