Ranking Reversal Problem

A further and more serious conflict can arise between NPV and IRR methods when projects differ significantly in terms of the magnitude and timing of cash flows. When the size or pattern of alternative project cash flows differ greatly, each project's NPV can react quite differently to changes in the discount rate. As a result, changes in the appropriate discount rate can sometimes lead to reversals in project rankings.

To illustrate the potential for conflict between NPV and IRR rankings and the possibility of ranking reversals, Table 15.5 shows a further development of the SVCC plant investment project example. Assume that the company is considering the original new plant investment project in light of an alternative proposal to buy and remodel an existing plant. Old plant and equipment can be purchased for an initial cash outlay of $11.5 million and can be remodeled at a cost of $2 million per year over the next 2 years. As before, a net working capital investment of $6.6 million will be required just prior to opening the remodeled production facility. For simplicity, assume that after year 2, all cash inflows and outflows are the same for the remodeled and new plant facilities.

Note that the new plant proposal involves an initial nominal cash outlay of $25.8 million, whereas the remodeled plant alternative involves a nominal cash outlay of $22.1 million. In addition to this difference in project size, the two investment alternatives differ in terms of the timing of cash flows. The new plant alternative involves a larger but later commitment of funds. To see the implications of these differences, notice how the "remodel old plant" alternative is preferred at and below the firm's 15 percent cost of capital using NPV and PI methods, even though the IRR of 25.06 percent for the new plant project exceeds the IRR of 23.57 percent for the "remodel old plant" alternative. Also troubling is the fact that the relative ranking of these projects according to NPV and PI methods is reversed at higher discount rates. Notice how the "build new plant" alternative is preferred using NPV and PI techniques when a 25 percent discount rate is employed.

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