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In ans to part (a) of the question, I did not understand this following part :-
The Internal Rate of return (IRR)
The ans mentions,” If the selection is between two projects with the same scale of investment (which is the case here), then it has no effect on which project is selected.”In case where 2 projects have same scale of Investment (PV of Cash Outflow) but different PV of Cash Inflows, IRR will ofcourse vary. Hence I did not understand this line in the answer.
As per my knowledge, a project which has its IRR greater than its cost of capital should be profitable and hence selected.
Also in the question, the two projects (1 and 2) have different scale of investment (PV of cash outflow) then why did the answer mention that the two projects have same scale of investment?
It is to do with whether NPV or IRR gives the better answer for which project to choose when they are mutually exclusive..
NPV tells you in absolute terms how much richer you would be; IRR tells you in relative terms how each project earns.
If the projects are of the same size with respect to investment then the project with the higher NPV will also have the higher IRR.
But, look at the following (discount rate = 10%):
Project A: investment = $1m. Returns = $200,000 pa in perpetuity.
Project B: investment = $100. Returns = $30 pa in perpetuity.A: NPV = -1m + 200,000/0.1 = $1m; IRR = 200,000/1,000,000 = 20%
B: NPV = = -100 + 30/0.1 = 200; IRR = 30/100 = 30%.
If you are concerned with maximising wealth, use NPV and choose project A as 1M>>>200.
If you want to maximise the company’s rate of return then adding a project returning 30% is better than adding one returning 20%
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