Unifying Concepts: Comparing the Internal Rate of Return and the Net Present Value Methods?

Question

Get Rich Corporation has to choose between two investment opportunities. Investment A requires an immediate cash outlay of $100,000 and provides after-tax income of $20,000 per year for 10 years. Investment B requires an immediate cash outlay of $1,000 and generates after-tax income of $350 per year for five years.
1. Using a cost of capital of 12%, calculate the net present value of each investment, and determine which one Get Rich should select.
2. Calculate the internal rate of return of each investment. On the basis of this method, which investment should Get Rich select?
3. Interpretive Question: How do you account for the difference in rankings? Under the circumstances, which method would you rely on for your decision?

Answer 1

1.) Investment A: NPV = 13,004.46 Investment B NPV = 261.67
Select Investment A

2.) Investment A IRR = 15.09% Investment B IRR = 22.10%
Select Investment B

The difference in rankings is due to the difference in scale of the projects. NPV is inappropriate unless Investment B is scalable. I would choose investment A because of the higher NPV. Otherwise you have a lot of cash sitting around getting an IRR of 0 that has to be accounted for.