Question

• For mutually exclusive projects, explain why picking one project over another because it has a larger IRR can lead to mistakes.
• Explain why ranking projects according to their NPV might not be optimal when you evaluate projects with different resource requirements.
• How can the profitability index be used to identify attractive projects when there are resource constraints?

Answer 1

ANswer A

In case of mutually exclusive projects, there maybe size disparity means the project may require different initial investment, or there may be case of time disparity ( i.e. projects having unequal cash flows pattern) . In such case the IRR technique may be misleading. The problem arises because if reinvestment rate assumption. IRR assumes that cash fliws will be reinvested at a rate equal to IRR

Answer B

The NPV shows the excess present value of cash inflows over its outflows. However in case of different resource requirements (i.e. cost of the project the NPV may be misleading technique. For example if the PVCI of Project A is 50000 with Capitla outlay of 40000, then NPV would be = 50000 - 40000 = 10000, whereas for project B having PVCI of 16000 with cost of project 10000, NPV would be 6000. If we compare NPV, the result will be acceptance of Project A having higher NPV. But It require the cash outlay of 40000 and it is ignored. On the other hand project B require only 10000 for getting NPV of 60000.

ANswer C

The Profitability Index shows the ratio of PVCI over PVCO. The PI for the example taken in B would be

PI(a) = PVCI/PVCO = 50000/40000 = 1.25

and PI(b) = 16000 / 10000 = 1.6  

So as per PI criteria Project B should be selected as it has higher PI. Thus at the time of resouce constraint, PI give the relative results and help to accept only those projects having higher relative profitability.