The IRR for A (24 percent) is larger than the IRR for B (21 percent). However, if you compare the NPVs, you'll see that which investment has the higher NPV depends on our required return. B has greater total cash flow, but it pays back more slowly than A. As a result, it has a higher NPV at lower discount rates.

In our example, the NPV and IRR rankings conflict for some discount rates. If our required return is 10 percent, for instance, then B has the higher NPV and is thus the better of the two even though A has the higher return. If our required return is 15 percent, then there is no ranking conflict: A is better.

The conflict between the IRR and NPV for mutually exclusive investments can be illustrated by plotting the investments' NPV profiles as we have done in Figure 9.8. In Figure 9.8, notice that the NPV profiles cross at about 11 percent. Notice also that at any discount rate less than 11 percent, the NPV for B is higher. In this range, taking B benefits us more than taking A, even though A's IRR is higher. At any rate greater than 11 percent, Project A has the greater NPV.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria

© The McGraw-Hill Companies, 2002

CHAPTER 9 Net Present Value and Other Investment Criteria

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