Question

Explain the difference between independent projects and mutually exclusive projects. When you are confronted with Mutually Exclusive Projects and have conflicts with NPV and IRR results, which criterion would you use (NPV or IRR) and why? P.S. I saw some answers on Chegg but I didn't like them, please do not use them

Answer 1

Independent projects are those projects where one project decision does not affect other Project and investing decisions. The projects are unrelated to each other and cash flow of one project is not affected by another project. They are evaluated on the basis of their own profitability.

Mutual exclusive projects are those projects where among various projects only one project is acceptable. If one project is accepted then other projects are automatically rejected. Unlike independent projects, the decision to invest in one project is dependent on the merits of all the projects.

In case of mutually exclusive projects, the project with the highest NPV or highest IRR or lowest payback period is selected even if other projects also have positive NPV or low payback period. Whereas in independent projects, if all the projects have positive NPV or the IRR is greater than the cost.

Now, in case of conflict between NPV and IRR in case of mutually exclusive projects, always select the project with higher NPV. The NPV method is selected because it has used the most realistic approach in finding the value of project by using the reinvestment rate . Also, in case of uneven cash flows ( which is practically going to happen) , NPV is more accurate and realistic approach because in case of IRR method there will be more than one IRR and it will be difficult to determine the exact rate . But NPV can easily estimate the value and profit from the project.
So NPV method is better indicator as compared to IRR while the projects are mutually exclusive.