1.31 Project Scale

Below we see two mutually exclusive projects, one of which requires greater investment and thus also, as it were, produces annual higher FCFs, – and NPV. The other has a smaller investment, but higher FCFs relative to the outlay – and a higher IRR. Put differently, the outlay for “A” is 50% higher than for “B,” the smaller project. However, the FCFs for “A” are only about 43% greater than for “B.”

We will use 10% as the discount rate for the NPV calculation. Note the conflict between the two indicated rules of thumb as below.

Year FCF Project A FCF Project B
0 ($3,000) ($2,000)
1 1,000 700
2 1,000 700
3 1,000 700
4 1,000 700
5 1,000 700
NPV $790.80 $653.55
IRR 19.86% 22.11%
PI 1.26 1.32

IRR and PI say accept “B,” while NPV says accept “A.”

The IRR is a measure of return, while the NPV provides a measure of the expected dollar increase in wealth. The NPV is largely affected by scale. The IRR and PI will yield consistent results with one another; these methods are more affected by inflows relative to outflows.

What should the company do?


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Corporate Finance Copyright © 2023 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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