When do NPV and IRR give conflicting signals, and which should I trust?
I understand that NPV and IRR are both capital budgeting tools, and they usually agree. But my CFA textbook says they can conflict in certain situations. When does this happen and what should I do?
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.
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When conflicts arise:
1. Different project scale: Project Alpha costs 200K). Project Bravo costs 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%):
| Project Peak | Project Valley | |
|---|---|---|
| Initial cost | -$500,000 | -$500,000 |
| Year 1 CF | $400,000 | $100,000 |
| Year 2 CF | $200,000 | $150,000 |
| Year 3 CF | $50,000 | $450,000 |
| IRR | 32.1% | 22.4% |
| NPV @ 10% | $82,300 | $97,600 |
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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