Question

Consider the capital budgeting decision to be made with the following data about 2 competing projects. Project A has an NPV of $250, and IRR of 2% and a payback period of 3 years. Project B has an NPV of -$100, but an IRR of 3% and a payback period of 2 years 10 months. Which project(s) would be chosen on a mutually exclusive basis?

Answer 1

Npv or the net present value tells how much additional value the project is going to add if undertaken.

Irr or internal rate of return is that return which makes npv zero.

Payback period gives the information on the amount of time required to get the initial investment back.

Mutually exclusive means selection of one leads to rejection of another.

Whenever there is a conflict between decisions on npv and irr, npv should be given preference as it tells absolute increase in the value. Irr is relative and also comparison needs to be done with the cost of the project. In itself it is just a number which gives little information. Payback period suffers from the drawback that it doesn't care about cashflows after payback period. Payback period doesn't give much useful information to decide which project to undertake.

A positive npv adds value and negative npv causes loss for the firm.

Thuas, project A should be undertaken as it has positive npv. Project B should not be undertaken as it has negative npv.

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