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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

Two mutually exclusive projects, P and Q, have IRRs of 22% and 17% respectively. At the company's cost of capital of 10%, NPV of P is Rs 80,000 and NPV of Q is Rs 120,000. Which recommendation follows from sound appraisal practice?

Choose Q. For mutually exclusive projects the NPV rule is preferred because it measures the absolute increase in shareholder wealth, whereas IRR can mis-rank projects of different scale or timing. Q's NPV of Rs 120,000 exceeds P's Rs 80,000.

  1. AChoose Q, because it has the higher NPV and so adds more shareholder wealthCorrect
  2. BChoose P, because it has the higher IRR
  3. CChoose neither, because the IRRs differ
  4. DChoose P, because its NPV is lower and so risk is lower
  5. Choose both, because both exceed the cost of capital

Explanation

For mutually exclusive projects, NPV maximises absolute shareholder wealth. IRR ignores scale and timing differences and can mislead ranking. Q adds Rs 120,000 versus Rs 80,000, so choose Q. Choosing both is impossible as they are mutually exclusive.

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