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IAI Actuarial Core Principles · Business Finance · Key principles of finance

A firm compares two mutually exclusive projects. Project X has the higher IRR, but Project Y has the higher NPV at the firm's cost of capital, and both have positive NPVs. Which course of action is consistent with the objective of maximising shareholder wealth?

Choose Project Y. NPV measures the absolute rupee increase in shareholder wealth, whereas IRR is a percentage that can favour smaller or faster-returning projects. When the two rankings conflict for mutually exclusive projects, NPV is the reliable criterion.

  1. AChoose X because a higher IRR always means a higher return in rupees
  2. BChoose Y because it adds more absolute value to shareholdersCorrect
  3. CReject both because their IRRs differ
  4. DChoose X because IRR is not affected by the scale of the project
  5. Choose the project with the shorter payback regardless of NPV

Explanation

For mutually exclusive projects, NPV measures the absolute increase in shareholder wealth. IRR is a percentage and can rank projects differently because of scale and timing of cash flows. So Y is preferred; the other options rely on IRR or payback which do not measure wealth added.

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