Corporate Accounting and Financial Management · Capital Budgeting

NPV vs IRR Conflicts and Capital Rationing Explained

Updated 11 October 2026 · Fact-checked

NPV and IRR can rank mutually exclusive projects differently because of differences in project size, cash-flow timing or project life. Resolve the conflict by choosing the higher NPV. Capital rationing means a fixed budget limits investment. Then you pick the combination of projects with the highest total NPV within the budget.

Understand NPV vs IRR Conflicts and Capital Rationing

Both NPV and IRR discount cash flows, so for a single project they give the same accept or reject decision. If NPV is positive, IRR is above the cost of capital. The trouble starts when you must compare projects, and especially when you must choose only one.

Mutually exclusive projects are projects where choosing one rules out the others, such as two different machines for the same job. Here the two methods can rank the projects in opposite order. This is a conflict in ranking.

The usual reasons are: (1) scale - one project needs a much larger outlay; (2) timing - one project returns cash early and the other returns it late; (3) life - the projects run for different periods. Behind all three sit different reinvestment assumptions. NPV assumes cash flows are reinvested at the cost of capital. IRR assumes they are reinvested at the project's own IRR. The NPV assumption is more realistic, and NPV measures the rupee increase in shareholder wealth. So when the two methods conflict, you follow NPV.

Capital rationing is the situation where a firm has more acceptable projects than funds. It may be external (the market will not lend or subscribe beyond a limit) or internal (management sets a budget ceiling for each division or period). Under rationing you cannot simply accept every project with positive NPV. You choose the set of projects that gives the highest total NPV within the budget.

If projects are divisible, rank by Profitability Index (PI) and fund in that order, taking a part of the last project. If projects are indivisible, PI ranking is only a starting point. You must test the feasible combinations and pick the one with the highest total NPV.

Key rules to remember

Net Present Value: NPV = Σ [CFt ÷ (1 + k)^t] − Initial outlay; k is the cost of capital. Accept if NPV > 0. Among mutually exclusive projects, choose the highest NPV.
Internal Rate of Return: IRR is the rate r at which Σ [CFt ÷ (1 + r)^t] = Initial outlay, i.e. NPV = 0; Accept if IRR > cost of capital. IRR is a rate, not a rupee gain, so it ignores scale.
Profitability Index: PI = PV of cash inflows ÷ Initial outlay = 1 + (NPV ÷ Initial outlay); PI > 1 means NPV > 0. Useful for ranking under capital rationing.
Crossover rate: Crossover rate = rate at which NPV of project A = NPV of project B (IRR of the incremental cash flows A − B); If cost of capital is below the crossover rate, the methods may conflict. Above it, they agree.
Decision rule for conflict: Mutually exclusive projects: choose the highest positive NPV; Reason: NPV assumes reinvestment at the cost of capital and maximises shareholder wealth.
Rationing rule: Choose the feasible set with the highest total NPV subject to Σ outlays ≤ budget; For divisible projects, rank by PI. For indivisible projects, compare combinations.

How to solve NPV vs IRR Conflicts and Capital Rationing questions

Use this order for any question on conflicts or capital rationing.

1Read the question and decide whether the projects are independent, mutually exclusive, or subject to a budget limit.
2List the cash flows of each project and the cost of capital given.
3Compute NPV for each project using the discount factors given. Compute PI if the budget is limited.
4Find IRR by trial and interpolation if asked, or use the IRR provided. Rank the projects separately by NPV and by IRR.
5If rankings differ for mutually exclusive projects, state the reason (scale, timing or life) and recommend the project with the higher NPV.
6Under capital rationing, rank by PI first. Then list the feasible combinations within the budget, add their NPVs, and pick the highest total.
7Check that total outlay does not exceed the budget. Write a clear conclusion with the chosen project(s) and the total NPV.

Quickest way: NPV-first shortcut

When to use it: Use when time is short and the question asks you to recommend a project or a set of projects.

Compute NPV of every project first. Do IRR only if the question asks for it.
Mutually exclusive: pick the highest NPV. Mention that IRR may mislead because of scale or timing.
Budget limit: compute PI, rank, fill the budget, then test one or two alternative combinations.
Unspent money can be assumed to earn nothing unless the question says otherwise. Do not add anything for it.
Write the conclusion in one line with the NPV figure.

Common mistakes in NPV vs IRR Conflicts and Capital Rationing

Choosing the project with the higher IRR when it conflicts with NPV.
IRR is a percentage and looks easy to compare.
Fix: For mutually exclusive projects, always choose the higher NPV, since it shows the rupee gain to shareholders.
Saying the conflict arises because one method is wrong.
Students do not link the conflict to its cause.
Fix: State the cause: differences in scale, timing or life, and the different reinvestment assumptions (cost of capital for NPV, IRR for IRR).
Accepting all positive-NPV projects under capital rationing.
The budget limit is overlooked.
Fix: Check total outlay against the budget. Select the combination with the highest total NPV within it.
Ranking by PI alone when projects are indivisible.
PI ranking is taught as the rule for rationing.
Fix: Use PI to start, then test other combinations. A lower-PI project may fit the budget better and give a higher total NPV.
Using NPV (not PI) to rank when the budget is limited, then ignoring the size of outlay.
A large project with the biggest NPV uses up most of the budget.
Fix: Compare NPV per rupee of outlay (PI) and then check the total NPV of combinations.
Applying the IRR rule to compare projects with unequal lives without adjustment.
Students assume the methods give a like-for-like comparison.
Fix: Mention the issue and prefer NPV. If asked, compare on a common life or use equivalent annual figures.

Worked examples

Example 1

A company with a cost of capital of 10% must choose one of two mutually exclusive projects. Each needs an outlay of ₹10,000. Project X inflows: Year 1 ₹10,000, Year 2 ₹1,000, Year 3 ₹1,000. Project Y inflows: Year 1 ₹1,000, Year 2 ₹1,000, Year 3 ₹12,000. IRR of X is about 16% and of Y about 13%. Which project should be chosen? Discount factors at 10%: 0.9091, 0.8264, 0.7513.

Show the solution

PV of inflows of X = 10,000 × 0.9091 + 1,000 × 0.8264 + 1,000 × 0.7513 = 9,091 + 826.4 + 751.3 = ₹10,668.7.
NPV of X = 10,668.7 − 10,000 = ₹668.7, about ₹669.
PV of inflows of Y = 1,000 × 0.9091 + 1,000 × 0.8264 + 12,000 × 0.7513 = 909.1 + 826.4 + 9,015.6 = ₹10,751.1.
NPV of Y = 10,751.1 − 10,000 = ₹751.1, about ₹751.
Ranking by IRR: X (about 16%) is above Y (about 13%). Ranking by NPV: Y (₹751) is above X (₹669). The rankings conflict.
Reason: the cash flows differ in timing. X returns most cash in Year 1, which favours IRR. Y returns most cash late. IRR assumes reinvestment at the project's own IRR, while NPV assumes reinvestment at 10%, which is more realistic.
Since the projects are mutually exclusive, the NPV rule applies.

Answer: Choose Project Y, as its NPV of about ₹751 is higher than X's ₹669, even though X has the higher IRR. NPV shows the larger gain in shareholder wealth.

Example 2

A company has a capital budget of ₹5,00,000. The projects are indivisible and cannot be repeated. Details (outlay, NPV): A ₹2,00,000, ₹50,000; B ₹3,00,000, ₹66,000; C ₹1,50,000, ₹45,000; D ₹1,00,000, ₹20,000; E ₹2,50,000, ₹40,000. Select the best set of projects.

Show the solution

PI = 1 + NPV ÷ outlay. A = 1 + 50,000 ÷ 2,00,000 = 1.25. B = 1 + 66,000 ÷ 3,00,000 = 1.22. C = 1 + 45,000 ÷ 1,50,000 = 1.30. D = 1 + 20,000 ÷ 1,00,000 = 1.20. E = 1 + 40,000 ÷ 2,50,000 = 1.16.
PI ranking: C, A, B, D, E.
Fund in PI order: C (₹1,50,000) and A (₹2,00,000) use ₹3,50,000. B needs ₹3,00,000, which exceeds the balance of ₹1,50,000, so skip it. D (₹1,00,000) fits. Total outlay ₹4,50,000, NPV = 45,000 + 50,000 + 20,000 = ₹1,15,000.
Test other combinations within ₹5,00,000: A + B = ₹5,00,000, NPV = 50,000 + 66,000 = ₹1,16,000. B + C = ₹4,50,000, NPV = ₹1,11,000. C + D + E = ₹5,00,000, NPV = 45,000 + 20,000 + 40,000 = ₹1,05,000. A + E = ₹4,50,000, NPV = ₹90,000.
The highest total NPV among the feasible combinations is ₹1,16,000 from A + B.

Answer: Select Projects A and B. They use the full ₹5,00,000 and give the highest total NPV of ₹1,16,000. PI ranking alone would give C, A and D with NPV of ₹1,15,000, which is lower.

Exam tips

Write the cause of a conflict in one line (scale, timing or life) and then give your conclusion. Examiners reward the reasoning.
Always show the NPV workings with the discount factors given. Marks are awarded for steps even if a figure slips.
For rationing questions, state whether projects are divisible or indivisible before you start, because it decides the method.
Define capital rationing and its two types (external and internal) in two lines if the question asks for the meaning.
Finish every answer with a clear recommendation, such as 'Select Project Y' or 'Select A and B', and the total NPV.

Practice questions from Capital Budgeting

NPV vs IRR Conflicts and Capital Rationing in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

NPV vs IRR Conflicts and Capital Rationing: frequently asked questions

Why do NPV and IRR give different rankings?

They differ when projects have different sizes, different timing of cash flows or different lives. NPV assumes reinvestment at the cost of capital, while IRR assumes reinvestment at the project's own IRR. This makes the rankings differ.

Which method should I prefer when NPV and IRR conflict?

Prefer NPV for mutually exclusive projects. It gives the rupee increase in shareholder wealth and uses a more realistic reinvestment rate.

What is capital rationing and what are its types?

Capital rationing is a situation where a firm cannot invest in all acceptable projects because funds are limited. It can be external, due to limits in the capital market, or internal, due to a budget ceiling set by management.

How do I solve a capital rationing problem?

Compute NPV and PI for each project. Rank by PI and fill the budget. For indivisible projects, also test other combinations within the budget and pick the one with the highest total NPV.

Can NPV and IRR conflict for independent projects?

For a single conventional project, both give the same accept or reject decision. Conflicts matter mainly when you rank mutually exclusive projects.