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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

Two mutually exclusive projects have conventional cash flows. Project X has an IRR of 18% and an NPV of 40,000 at the firm's cost of capital. Project Y has an IRR of 14% and an NPV of 55,000 at the same rate. The firm is not capital constrained. The most appropriate decision is to:

Choose Project Y because it has the higher NPV. For mutually exclusive projects, NPV directly measures value added to shareholders, so it governs when it conflicts with IRR ranking, which can be distorted by differences in project scale or cash flow timing.

  1. Achoose Project X because of its higher IRR
  2. Bchoose Project Y because of its higher NPVCorrect
  3. Cchoose both projects because both IRRs exceed the cost of capital

Explanation

For mutually exclusive projects, NPV measures the increase in shareholder wealth, so the project with the larger NPV is chosen. IRR can rank projects differently because of scale and timing differences. Choosing both ignores that only one can be undertaken.

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