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NPV, PI and IRR Differenciations ???

afrika (student) (24 Points)

07 December 2010

Hello,

I failed a job interview, where i was asked under what circumstances woudl NPV, PI and IRR methods ( In capital Budgetting ) provide different rankings ?

I said, based on the discount factor and interest rates.

I wasnt told if i was correct or wrong, i was simply told, i failed.

Whaat did i do or say wrong ?

thanks

Ehi

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Rahul (Entrepreneur) (32 Points)
Replied 19 December 2010

Hi there! Sorry to hear that.

The answer to the question should be clear if one comes to grip with the concepts.

IRR measures the return potential of the project, while not considering the involved funding costs (i.e. WACC). NPV incorporates both in a single metric (following the EVA concept!).

Profitability Index is similar to NPV (i.e. instead of subtracting the initial investment it is divided by it giving PI = PV/Initial investment)

Now that we know the concept, it is easy to see that there will NEVER be a conflict between NPV and PI (as both have the same underlying principles).

However, the same cannot be said about the NPV vs IRR.

The conflict stems from the fact that IRR does not take the costs of generating such returns at all. That is, it does not pay heed to WACC and hence changes in capital structure & risk are simply not captured in IRR. So Project A could have a higher IRR than project B, but the latter could have a lower WACC in relation to its IRR and hence be preferred!

Bottom-Line: While there will be no difference in judgment when using NPV or PI methods. However, the conflicts between decisions made by NPV & IRR are a result of capital structure and perceived risk (that IRR fails to capture!).

The article below will help!

https://finaticsonline.com/blog/2010/11/npv_vs_irr_vs_mirr/

...and don't feel let down by the experience, they say "Luck is what happens when preparation meets opportunity". Better luck next time!