When do NPV and IRR give conflicting signals, and which should I trust?

This is a classic CFA Level I corporate finance question. NPV and IRR usually point to the same accept/reject decision for independent projects, but they can conflict when ranking mutually exclusive projects or when cash flow patterns are unusual.

When conflicts arise:

1. Different project scale:

Project Alpha costs $1M and has an IRR of 25% (NPV = $200K). Project Bravo costs $10M and has an IRR of 18% (NPV = $1.2M). IRR says Alpha is better; NPV says Bravo creates more value. NPV is correct — Bravo adds $1.2M in wealth.

2. Different cash flow timing:

Project with early cash flows tends to have a higher IRR. Project with later but larger cash flows may have a higher NPV at your cost of capital.

3. Non-conventional cash flows:

If cash flows switch signs multiple times (e.g., initial investment, positive CFs, then a large cleanup cost), IRR can produce multiple solutions or no solution. NPV always gives one clear answer.

The reinvestment rate assumption:

• IRR assumes intermediate cash flows are reinvested at the IRR itself — often unrealistically high
• NPV assumes reinvestment at the cost of capital — more realistic

Example: Ridgeline Mining evaluates two mutually exclusive projects (cost of capital = 10%):

IRR prefers Peak; NPV prefers Valley. Choose Valley — it creates $15,300 more shareholder wealth.

The rule: When NPV and IRR conflict, always follow NPV. NPV directly measures wealth creation, which is the goal of the firm.

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