Reasons for Decision Rule Conflict

As discussed earlier, NPV is the difference between the marginal revenues and marginal costs of an individual investment project, when both revenues and costs are expressed in present-value terms. NPV measures the relative attractiveness of alternative investment projects by the discounted dollar difference between revenues and costs. NPV is an absolute measure of the attractiveness of a given investment project. Conversely, the PI reflects the difference between the marginal revenues and marginal costs of an individual project in ratio form. The PI is the ratio of the discounted present value of cash inflows divided by the discounted present value of cash outflows. PI is a relative measure of project attractiveness. It follows that application of the NPV method leads to the highest ranking for large profitable projects. Use of the PI method leads to the highest ranking for projects that return the greatest amount of cash inflow per dollar of outflow, regardless of project size. At times, application of the NPV method can create a bias for larger as opposed to smaller projects—a problem when all favorable NPV > 0 projects cannot be pursued. When capital is scarce, application of the PI method has the potential to create a better project mix for the firm's overall investment portfolio.

Both NPV and PI methods differ from the IRR technique in terms of their underlying assumptions regarding the reinvestment of cash flows during the life of the project. In the NPV and PI methods, excess cash flows generated over the life of the project are "reinvested" at the firm's cost of capital. In the IRR method, excess cash flows are reinvested at the IRR. For especially attractive investment projects that generate an exceptionally high rate of return, the IRR can actually overstate project attractiveness because reinvestment of excess cash flows at a similarly high IRR is not possible. When reinvestment at the project-specific IRR is not possible, the IRR method must be adapted to take into account the lower rate of return that can actually be earned on excess cash flows generated over the life of individual projects. Otherwise, use of the NPV or PI methods is preferable.

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