Which model is better for independent projects - net present value or internal rate of return? For mutually exclusive projects? Explain your reasoning for each case

Answer 1

For independent projects, both net present value and internal rate of return will yield the same decision. If the net present value is positive, then the internal rate of return is above the minimum required amount. However, for competing (mutually exclusive) projects, the situation is different, since the two models can signal different results. NPV differs from IRR in two significant ways. First, NPV assumes that each cash inflow received is reinvested at the required rate of return, while IRR assumes that the cash inflow in reinvested at the project's own internal rate of return. This may not be realistic. Second, NPV is a dollar measure while IRR is not. Thus, a "better" project in terms of IRR may yield less profit over the life of the project than one with a positive NPV but a lower IRR. As a result, for competing projects, it is usually better to use NPV.