IRR: Mutually exclusive projects

Defender vs Challenger

Two projects, X and Y cash flows of –1000, 600, 600, 200, and –1000, 0, 800, 700 respectively ; using
defender/challenger which one should be chosen? The hurdle rate is 10%.

How to solve;

1. Work out which project has the higher total cash flows. Label it the Defender (here it is
Project Y), the other project will be the challenger (Project X).
2. Subtract the challenger cash flows from the defender (Y – X).
3. You now have the incremental cash flows between the two projects.
4. Calculate the IRR of the incremental cash flows. The IRR works out at 9.46%.
5. If the IRR is greater than the hurdle rate (10%) you would keep the defender. If the IRR is
less than the hurdle rate you accept the challenger. Here the IRR is 9.46% so reject the
defender and accept the challenger (Project X).
6. The IRR is calculated by trial and error.

(but if you don’t have enough time to calculate the IRR, you can discount the incremental cash flows
by the hurdle rate (10%). If you get a negative NPV it means you have an IRR less than the hurdle rate
(9.46% here) and you would reject the defender. Discounting by the hurdle rate and a positive answer
would mean that the IRR is greater than the hurdle rate and you would keep the defender. This is
much quicker than doing IRR by trial and error. If you had the choice you would always use NPV. For
people who don’t use NPV, and IRR is still almost as widely used as NPV, the defender – challenger
method, will indicate which project is preferable among mutually exclusive projects.)
IRR - Defender vs Challenger

Total

Year 0 1 2 3 Cash flows

X -1000 600 600 200 400 Challenger

Y -1000 0 800 700 500 Defender (Largest cash flows)

Cash Flows: Y - X

year 0 1 2 3

0 -600 200 500

Work out IRR of these cash flows = 9.46%

ie what discount rate discounts -600, 200 and 500 to give 0?

Rule:

If this rate is greater than hurdle rate - accept defender

If this rate is greater than hurdle rate - accept challenger

Hurdle rate = 10%, IRR is less than this so accept challenger.

We undertake project X

[NPV X = 191, NPV Y = 187]