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Incremental Approach

The conflict between the NPV anti IRR in the above situation can be resolved by modifying the IRR so that it is based on incremental analysis. According to the incremental approach, when the IRR of two mutually exclusive projects whose initial outlays are different exceeds the required rate of return, the lRR of the incremental outlay of the project requiring a bigger initial investment should be calculated. This involves the following steps:

1. Find out the differential cash flows between the two proposals.

2.  Calculate the IRR of the incremental cash flows.

3. If the IRR of the differential cash flows exceeds the required rate of return, the project having greater investment outlays should be selected, otherwise it should be rejected.

The logic behind the incremental approach is that the film would get the profits promised by the project involving smaller outlay plus a profit on the incremental outlay. In general, projects requiring larger outlay would be more profitable if IRR on differential cash outlays exceeds the required rate or return. The modified IRR for mutually exclusive proposals involving size-disparity problem would provide an accept-reject decision identical to that given by the NPV method .

In Example, the IRR of the differential cash outlay of Project B, is 16 per cent. The required rate of return is 10 per cent. Thus, project B is better than project A in spill of the fact that IRR in the lower because it offers the benefits offered by project A plus a return in excess of the required return on Rs 2,500, that is, differential cash outlays.

To summarize the above discussion, the NPV method is superior to the IRR because the former supports projects which are compatible with the goal of maximization of shareholders wealth while the latter does not. On modifying the IRR method by adopting the incremental approach, IRR would give results identical to the NPV method. The modified IRR method has other merits also. It is easier to interpret and apply than the NPV measure. However, it requires additional computation, whereas the NPV method provides the correct answer in the first instance itself.

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