Ranking Mutually Exclusive Projects
The net present value (NPV) and internal rate of return (IRR) methods yield the same accept or reject rule in case of independent conventional investments. However, in real business situations there are alternative ways of achieving an objective and, thus, accepting one alternative will mean excluding the other. Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded.
For example, in order to distribute its products a company may decide either to establish its own sales organization or engage outside distributors. The more profitable out of the two alternatives shall be selected. This type of exclusiveness may be referred to as technical exclusiveness. On the other hand, two independent projects may also be mutually exclusive if a financial constraint is imposed. If limited funds are available to accept either project X or project Y, this would be an example of financial exclusiveness or capital rationing. The NPV and IRR methods can give conflicting ranking to mutually exclusive projects. In the case of independent projects ranking is not important since all profitable projects will be accepted. Ranking of projects, however, becomes crucial in the case of mutually exclusive projects. Since the NPV and IRR rules can give conflicting ranking to projects, one cannot remain indifferent as to the choice of the rule.
The net present value (NPV) and internal rate of return (IRR) rules will give conflicting ranking to the projects under the following conditions:
- The cash flow pattern of the projects may differ. That is, the cash flows of one project may increase over time, while those of others may decrease of vice versa.
- The cash outlays of the projects may differ.
- The projects may have different expected lives.
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