The reasons for conflicting results of NPV and IRR
methods (due to differences in cash flow patterns and
different lives of projects)
The IRR method implicitly assumes that funds (each inflow) can be
reinvested at the internal rate of return over the remaining life of the
project. The NPV method, however, implicitly, assumes reinvestment
at a rate equivalent to the required rate of return (used as the
discount rate).
This is what we mean by reinvestment of each inflow at the required
rate of return:
This will help you to understand why differences in cash flow patterns
of projects may result in contradictions when NPV & IRR results are
compared.
EXAMPLE OF DIFFERENCE IN PATTERN OF INFLOWS:
NET CASH FLOWS
____________________________________________________
Project D | Project I
Amount D Factor PV at 8% | Amount D Factor PV at 8%
End of Year 0 -$1,200 -$1,200 | -$1,200 -$1,200
1 1,000 0.926 926 | 100 0.926 93
2 500 0.856 426 | 600 0.856 514
3 100 0.794 79 | 1,080 0.794 857
Net Present 231 | 264
Value (lower NPV) | (higher NPV)
|
IRR ………………………………… 23% I 17%
(higher IRR) (lower IRR)
Note: One of the reasons for different IRRs is the major difference in the pattern of inflows.
RE-INVESTMENT FOR EACH CASH INFLOW EXPLAINED
In our above example the scale and lives of the projects are identical, so the conflicting results
cannot be due these factors. The observed conflict among methods is due to implicit
assumptions with respect to the reinvestment rate on intermediate cash inflows released from
the projects. Thus the IRR method implicitly assumes that funds (each inflow) can
be reinvested at the internal rate of return over the remaining life of the
project. The NPV method, however, implicitly, assumes reinvestment at a rate
equivalent to the required rate of return (used as the discount rate ).
In IRR method reinvestment rates are different as IRRs for each project will
almost always be different and will differ greatly if cash flow patterns are
radically different. This means that greater the difference in cash flow patterns greater
will be difference in re-investment rates. In the above example in case “D”, reinvestment is at
23% and in case of “I” it at 17%.
With the NPV method, the implicit reinvestment rate (required rate of return ) is the
same (8%) for each project.
When mutually exclusive projects are ranked differently because of cash-flow-pattern
differences, the NPV rankings should be used. In this way we can identify the project that
adds most value to shareholders wealth.
REASON WHY UNEQUAL LIVES MAY GIVE CONFLICTING RESULTS
Reason for conflicting results:
In case of Project X, the discount rate of 50%(IRR) hits harder in year 3
as compared to required rate of return (10%) applied for NPV method.
So in case of NPV the value of Rs 3,375 does not reduce much.
3,375 discounted for 3 years at 50% (Internal Rate of Return) = Rs 1,000
3,375 discounted for 3 years at 10% (Required Rate of Return) = Rs 1,536
In case of Project Y, in year 1 the 50% IRR will not be enough to
equalize Rs2,000 with Rs1,000. So much higher discount rate
(IRR=100%) is required; but because of lower value of inflow (Rs 2000
instead of Rs 3,375) NPV is lower.
To understand the effect of different lives better, assume the inflow
(Rs 2,000) of Project Y is also in year 3. Both methods will lead you to
the conclusion that Project X should be selected (ie no conflict).
SPECIAL APPLICATIONS OF CASH FLOW EVALUATION
Misapplication of the NPV method can lead to errors when
two mutually exclusive projects have unequal lives. There are
also situations in which an asset should not be operated for its full life. The
following sections explain how to evaluate cash flows in these situations.
Note that a replacement decision involves comparing two mutually exclusive
projects: retaining the old asset versus buying a new one. When choosing
between two mutually exclusive alternatives with
significantly different lives, an adjustment is necessary. For
example, suppose a company is planning to modernize its production facilities, and
it is considering either a conveyor system (Project C) or some fork lift
trucks (Project F) for moving materials. Figure below shows both the
expected net cash flows and the NPVs for these two mutually exclusive
alternatives.
Although the NPV shown in the Figure suggests that Project C should be
selected this analysis is incomplete, and the decision to choose Project C is
actually incorrect. If we choose Project F, we will have an opportunity to
make a similar investment in three years, and if cost and revenue conditions
continue, this second investment will also be profitable. However if we choose
Project C, we cannot make this second investment.
The REPLACEMENT CHAIN APPROACH & EQUIVALENT ANNUAL
ANNUITY APPROACH for comparing projects with unequal lives
Replacement Chain Approach The key to the replacement chain approach
is to analyze both projects using a common life. We assume that Project F can be
repeated after 3 years. In this case of life Project F is also extended to 6 years.
Project F with opportunity to reinvest
Project C’s NPV = $7,165 Project F’s NPV = $9,281
What is the 'Equivalent Annual Annuity Approach - EAA'.
The equivalent annual annuity (EAA) approach calculates the constant
annual cash flow generated by a project over its lifespan if it was an
annuity. The present value of the constant annual cash
flows is exactly equal to the project's net present
value (NPV). When used to compare projects with unequal lives, the one
with the higher EAA should be selected.
BREAKING DOWN 'Equivalent Annual Annuity Approach - EAA'
The EAA approach uses a three-step process to compare
projects:
1. Calculate each project's NPV over its lifetime.
2. Compute each project's EAA, such that the present value of the
annuities is exactly equal to the project NPV.
3. Compare each project's EAA and select the one with the
highest EAA.
For example, assume that a company with a weighted average cost of
capital (WACC) of 10% is comparing two projects, A and B. Project A has a
NPV of $3 million and an estimated life of five years, while Project B has
a NPV of $2 million and an estimated life of three years. Using a
financial calculator*, Project A has an EAA of $791,392.44, and Project B
has an EAA of $804,229.61. Under the EAA approach, Project B would
be selected sin ce it has the higher equivalent annual annuity value.
For A Pvan = 3,000,000 ; i = 0.1 ;n = 5 ;R = ? R = 3,000,000/3.79079
Equivalent annual annuity = R = $791,392
For B Pvan= 2,000,000 ; i = 0.1 ;n = 3 : R= ? R=2,000,000/2.48685
Equivalent annual annuity = R = $804,229
PV for A = 791,392/1.1 +791,392/(1.1)² + 791,392/(1.1)³ + 791,392/(1.1)4 +791,392/(1.1)5
= $ 3,000,000
PV for B = 804,229/1.1 + 804,229/(1.1)² + 804,229/(1.1)³ = $ 2,000,000
Per year cash inflow of Project B is larger ($804,229) as compared to
the per year cash inflow ($791,392) of Project A.
The EAA approach is relatively easier to use rather than the
other method used to compare projects with unequal lives, the
replacement-chain or common life approach.
*How to Calculate EAA using financial calculator? Explained below.
Most financial calculators would use the following inputs:
Project A – N (project life) = 5, i (WACC) = 10%, PV = -3,000,000, FV = 0,
compute PMT (the answer should be 791,392.44).
Project B – N (project life) = 3, i (WACC) = 10%, PV = -2,000,000, FV = 0,
compute PMT (the answer should be 804,229.61).
How to calculate IRR by using a financial calculator?
The steps for two popular calculators, the HP-10-B and the HP-17B, are shown below.
HP-10BB:
1. Clear the memory
2. Enter CF0 as follows: 1000 +/- CFj.
3. Enter CF1 as follows: 500 CFj.
4. Repeat the process to enter the other cash flows. Note that CF 0, CF 1, and so forth, flash on
the screen as you press the CFj button. If you hold the button down, CF 0 and so forth, will
remain on the screen until you release it.
5. Once the CFs have been entered, enter k = I =10%: 10 I/YR.
6. Now that all of the inputs have been entered, you can press NPV to get the answer, NPV =
$78.82.
7. If a cash flow is repeated for several years, you can avoid having to enter the CFs for each
year. For example, if the $500 cash flow for Year 1 had also been the CF for Years 2 through 10,
making 10 of these $500 cash flows, then after entering 500 CFj the first time, you could enter
10 Nj . This would automatically enter 10 CFs of 500.
HP-17B:
1. Go to the cash flow (CFLO) menu, clear if FLOW(0) = ? does not appear on the screen.
2. Enter CF0 as follows: 1000 +/ INIPUT.
3. Enter CF1 as follows: 500 INPUT.
4. Now, the calculator will ask you if the 500 is for Period 1 only or if it is also used for several
following periods. Since it is only used for Period 1, press INPUT to answer “1.” Alternatively,
you could press EXIT and then #T? to turn off the prompt for the remainder of the problem. For
some problems you will want to use the repeat feature.
5. Enter the remaining CFs, being sure to turn off the prompt or else to specify “ 1” for each
entry.
6. Once the CFs have all been entered, press EXIT and then CALC.
7. Now enter k =I =10% as follows: 10 I%
8. Now press NPV to get the answer, NPV = £78.82.
To find the IRR with an HP- l0B or HP-17B, repeat the steps given above. Then
with an HP-l0B, press IRR/YR and, after a pause, 14.49, Project’s IRR, will
appear. With the HP-17B, simply press IRR% to get the IRR. With both
calculators, you would generally want to get both the NPV and the IRR after
entering the input data, before clearing the cash flow register.
