Question

1. Provide two conditions under which a set of projects might be characterized as mutually exclusive.

2. Under what circumstances might the IRR and NPV approaches produce conflicting results?

Answer 1

1. Provide two conditions under which a set of projects might be characterized as mutually exclusive.

A set of projects are considered mutually exclusive when if one project is taken the other project cannot be taken.

• Resource constraint: There is no capital to invest in both the projects
• The two projects are of similar type. Taking one project makes the other project redundant.

2. IRR and NPV approaches produce conflicting results when the projects are mutually exclusive and the size of investments differ significantly in two projects.

Example: Project 1: Initial investment is $10,000. One year cash flow is $20,000

IRR = 100%

NPV at 10% discount rate = -10,000 + 20,000/1.1 = $8,181.8181818182

Project 2: Initial investment is $1,000,000. One year cash flow is $1,250,000

IRR = 25%

NPV at 10% discount rate = -1,000,000 + 1,250,000/1.1 = $136,363.636363636

If we go by IRR rule we would accept project 1 because its IRR (100%) is greater than the IRR of project 2 (25%)

But, the dollar amount we would make is only $8,181.8181818182 from project 1.

Therefore, whenever IRR rule and NPV rule conflicts, we should always go with NPV rule. NPV rule is superior to any other rule