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7. Understanding the NPV profile If an independent project with conventional, or normal, cash flows is being analyzed, the net present value (NPV) and internal rate of return (IRR) methods agree. Projects W and X are mutually exclusive projects. Their cash flows and NPV profiles are shown as follows. Year Project w -$1,000 0 Project x -$1,500 $350 1 $200 $350 2 $500 $600 3 $400 4 $600 $750 000 N w P 800 600 Project X 400 NPV (Dollars) Project w 200 200 2 4 18 10 20 10 12 14 COST OF CAPITAL (Percent) If the required rate of return for each project is 14%, do the NPV and IRR methods agree or conflict? The methods conflict. The methods agree 11:35 5/24/2 -200 0 2 4 6 8 10 12 14 16 18 20 COST OF CAPITAL (Percent) If the required rate of return for each project is 14%, do the NPV and IRR methods agree or conflict? modified internal rate of return (MIRR) required rate of return internal rate of return (IRR) Ake reinvestment rate. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at and the IRR calculation assumes that the rate at which cash flows can be reinvested is the the is usually the better decision criterion. As a result, when evaluating mutually exclusive projects, the Grade It Now Save & Continue Continue without saving -200 D 2 4 18 20 8 8 10 12 14 16 COST OF CAPITAL (Percent) If the required rate of return for each project is 14%, do the NPV and IRR methods agree or conflict? The methods conflict. internal rate of return (IRR) modified internal rate of return (MIRR) required rate of return ned reinvestment rate. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at and the IRR calculation assumes that the rate at which cash flows can be reinvested is the is usually the better decision criterion. As a result, when evaluating mutually exclusive projects, the Grade It Now Save & Continue Continue without saving 11:36 5/24/ -200 02 10 18 20 4 6 8 10 12 14 COST OF CAPITAL (Percent) If the required rate of return for each project is 14%, do the NPV and IRR methods agree or conflict? The methods conflict. The methods agree. A key to resolving this conflict is the assumed reinvestment rate. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at the and thIRR method in assumes that the rate at which cash flows can be reinvested is the NPV method As a result, when evaluating mutually exclusive projects, the 1 is usually the better decision criterion. Grade It Now Save & Continue Continue without saving 0 N

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