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CA Final · Advanced Financial Management · Advanced Capital Budgeting Decisions

Which statement correctly describes why NPV and IRR may give conflicting rankings for two mutually exclusive projects?

Conflicts arise because IRR implicitly assumes interim cash flows are reinvested at the project's own IRR, whereas NPV assumes reinvestment at the cost of capital. With differences in project scale or cash flow timing, the two methods can rank mutually exclusive projects differently.

  1. AIRR assumes reinvestment of intermediate cash flows at the cost of capital, while NPV assumes reinvestment at the IRR
  2. BNPV assumes reinvestment of intermediate cash flows at the project's IRR, while IRR assumes reinvestment at the cost of capital
  3. CIRR assumes reinvestment of intermediate cash flows at the project's own IRR, while NPV assumes reinvestment at the cost of capitalCorrect
  4. DConflict arises only because NPV ignores the time value of money

Explanation

NPV implicitly reinvests interim inflows at the cost of capital, a realistic assumption. IRR implicitly reinvests at the IRR itself, which can be unrealistically high. Differences in scale or timing of cash flows then cause ranking conflict. The reverse statements are wrong.

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