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CMA Intermediate · Financial Management and Business Data Analytics · Capital Budgeting

Two mutually exclusive projects of the same size give conflicting signals: Project M has the higher IRR, while Project N has the higher NPV at the firm's cost of capital. Which decision rule is the better guide for the finance manager?

The firm should choose Project N, the one with the higher NPV. NPV measures the absolute rupee increase in shareholder wealth and assumes reinvestment at the cost of capital, whereas IRR can mislead on mutually exclusive projects because it ignores scale and assumes reinvestment at the IRR.

  1. ASelect Project M, because IRR is a percentage and is unaffected by the scale of the project
  2. BSelect Project N, because NPV measures the absolute addition to shareholder wealth and assumes reinvestment at the cost of capitalCorrect
  3. CSelect Project M, because a higher IRR always implies a higher NPV at every discount rate
  4. DReject both projects until the IRRs of the two projects are equal

Explanation

For mutually exclusive projects, the goal is to maximise shareholder wealth in rupees. NPV does this directly and assumes cash flows are reinvested at the cost of capital, which is realistic. IRR assumes reinvestment at the project's own IRR and ignores scale, so the higher IRR does not guarantee the higher NPV.

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