Final answer:
The Net Present Value (NPV) and Internal Rate of Return (IRR) are two methods used to evaluate the profitability of investments. They may provide different decisions when choosing between mutually exclusive projects or when dealing with non-conventional cash flows.
Step-by-step explanation:
The Net Present Value (NPV) and Internal Rate of Return (IRR) are two commonly used methods to evaluate the profitability of an investment. The NPV calculates the present value of the expected cash flows, taking into account the required rate of return. If the NPV is positive, the investment is considered acceptable. On the other hand, the IRR is the discount rate that makes the NPV equal to zero. If the IRR exceeds the required rate of return, the investment is considered acceptable.
The NPV and IRR could provide different decisions under certain circumstances:
- Mutually exclusive projects: When choosing between two or more projects, the NPV and IRR may provide conflicting decisions. This can occur when one project has a higher initial investment but generates higher cash flows in later years, leading to a higher NPV. However, the IRR may be lower for this project compared to a project with lower initial investment and earlier cash flows.
- Non-conventional cash flows: If the cash flows of an investment project change signs multiple times (i.e., positive and negative cash flows), the IRR may have multiple values. In such cases, the IRR may not provide a clear decision on whether to accept or reject the investment.
It is important to consider other factors such as the riskiness of the investments, the strategic goals of the company, and any specific constraints when making investment decisions.