There are circumstances where a company cannot invest in more than one project either due to scarce resources or it does not want to go for more than one option. Under these circumstances, it becomes very difficult to choose which project to invest in.
If there is no limitation and company can choose more than one project, then these projects are called independent projects. But, here we are talking about mutually exclusive projects. In deciding which project to choose for investment, the question arises whether we base our decision over NPV, IRR or ARR method.
Most of the time, NPV and IRR gives same analysis of the projects. That is, projects evaluated using NPV basis or IRR basis, both method ranks the projects equally. However, in some circumstances IRR and NPV evaluations rank the project quite differently. In this case, it becomes difficult to decide which evaluation method to give priority. In this case, we base our evaluation over the basis of NPV purely.
Example
ABC is considering investing in two projects. Due to limited funds available, it can choose one project for investment. The hurdle rate for the purpose of this example is 15 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. The following data available for two mutually exclusive projects:
Project X
NPV of the future cash flows = $ 2,500
IRR = 25 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}
Project Y
NPV of the future cash flows = $ 3,500
IRR = 27 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}
Required
Advice ABC which project it should undertake?
Solution
You can see, both the projects have positive net present value and IRR greater than the hurdle rate of 15 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. If company has sufficient funds available, it should choose both projects. However, limited scarce resources require the financial analyst to choose project X on the basis of greater NPV. So, ABC should undertake project X.