Final answer:
The conflict between NPV and IRR in evaluating mutually exclusive projects stems from different assumptions about the reinvestment of cash flows. NPV is generally favored over IRR in decision-making as it provides a direct estimate of the value addition to the firm without the unrealistic reinvestment rate assumptions accompanying IRR.
Step-by-step explanation:
Conflict between NPV and IRR
When evaluating mutually exclusive projects, a conflict between Net Present Value (NPV) and Internal Rate of Return (IRR) often arises due to differences in the distribution of cash flows over time and the scale of the investments. The IRR method assumes that the cash flows generated by a project will be reinvested at the project's own internal rate, which often isn't a realistic scenario, especially if the IRR is significantly higher than the market rate. Meanwhile, NPV assumes reinvestment at the firm's cost of capital, providing a more accurate reflection of the project's added value to the firm.
In cases where there is a conflict between the NPV and IRR methods, NPV is generally considered the more reliable criterion for decision-making. This is because NPV directly measures the increase in shareholder value, which is the ultimate financial goal of most firms. While both methods have their merits, when they offer differing conclusions, NPV is typically favored as it provides a direct estimate of the financial contribution to the firm, without the reinvestment rate assumptions that can make the IRR less reliable.
The conflict between NPV and IRR arises when there is a difference in the timing or scale of the cash flows. For example, one project may have higher initial cash inflows, resulting in a higher IRR, while another might have larger inflows in the later years and might have a higher NPV. When evaluating mutually exclusive projects, it is important to consider more than just the rate of return; it is essential to understand how the investment will impact the firm's value over time.