Why do NPV and IRR sometimes give different rankings for mutually exclusive projects, and which should I trust?

NPV and IRR can produce conflicting rankings for mutually exclusive projects due to differences in project scale, cash flow timing, or reinvestment rate assumptions. When they disagree, always follow NPV — it directly measures the dollar value added to the firm.

Why Conflicts Arise:

1. Scale Differences

A small project may have a higher IRR but a lower NPV than a large project.

2. Timing Differences

One project may return cash flows earlier (boosting its IRR) while another returns more cash later (higher NPV at certain discount rates).

3. Reinvestment Rate Assumption

IRR implicitly assumes cash flows are reinvested at the IRR itself, which may be unrealistically high. NPV assumes reinvestment at the cost of capital, which is more conservative and realistic.

Worked Example — Ashworth Manufacturing

Ashworth Manufacturing must choose between two mutually exclusive production line upgrades. The cost of capital is 10%.

IRR Calculation:

• Project Falcon IRR: 27.8%
• Project Osprey IRR: 18.2%

NPV at 10%:

• Project Falcon: $120K/1.10 + $100K/1.21 + $60K/1.331 - $200K = $46,093
• Project Osprey: $250K/1.10 + $300K/1.21 + $450K/1.331 - $800K = $123,516

The Conflict:

Falcon has a higher IRR (27.8% vs 18.2%) but Osprey has a higher NPV ($123,516 vs $46,093).

Why NPV Wins:

• NPV tells you the dollar amount of wealth created for shareholders
• A project with IRR = 50% on a $1,000 investment creates less value than a project with IRR = 15% on a $10 million investment
• NPV's reinvestment assumption (at the cost of capital) is more realistic than IRR's assumption (reinvest at the IRR)

The Crossover Rate:

There exists a discount rate at which both projects have the same NPV — this is the crossover rate. Below the crossover rate, the larger/later-cash-flow project (Osprey) has higher NPV. Above it, the smaller/earlier-cash-flow project (Falcon) has higher NPV.

Exam Tip: If a question asks which project to accept and NPV and IRR disagree, pick the project with the higher NPV. If asked to explain why they conflict, cite differences in scale, timing, or reinvestment assumptions.

Practice capital budgeting problems in our CFA Level I question bank.