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ACCA Strategic Professional · Advanced Financial Management · Discounted cash flow techniques

Kestrel Ltd must choose one of two mutually exclusive projects, both with the same life. Project X has NPV of $120,000 at the 10% cost of capital and IRR of 15%. Project Y has NPV of $95,000 at 10% and IRR of 22%. Assuming no capital rationing and that the cost of capital is correct, which recommendation is consistent with the wealth-maximisation objective?

Kestrel should choose Project X. For mutually exclusive projects, NPV gives the absolute addition to shareholder wealth at the correct cost of capital, and X adds $120,000 against $95,000 for Y. IRR is a percentage and can mislead when projects differ in scale or timing.

  1. AChoose Y because its IRR is higher
  2. BChoose X because its NPV is higherCorrect
  3. CChoose Y because it has a lower NPV and therefore lower risk
  4. DChoose neither because the IRRs differ

Explanation

NPV measures absolute increase in shareholder wealth, so for mutually exclusive projects the higher NPV is chosen when discounted at the correct cost of capital. IRR is a relative percentage measure and can rank projects differently due to differing scale or cash flow timing. Choosing Y on IRR would sacrifice $25,000 of value.

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