Corporate Finance Q44
44Mutually exclusive capital budgeting projects A and B have similar outlays,but different pattern of future cash flows. The required rate of return for both projects is 12 percent, at which the NPV and IRR turn out to be as follows:
| Cash Flows | ||||||||
| Year | 0 | 1 | 2 | 3 | 4 | NPV | IRR (%) | |
| Project A | -100 | 0 | 0 | 0 | 200 | 24.20 | 18.92 | |
| Project B | -100 | 40 | 40 | 40 | 40 | 19.19 | 21.86 | |
The appropriate investment decision in this case is to:
- Option : B
- Explanation : When valuing mutually exclusive projects, the decision should be made with the NPV method because this method uses the most realistic discount rate, namely the opportunity cost of funds. In the example, the reinvestment rate for the NPV project (here 12 percent) is more realistic than the reinvestment rate for the IRR method (here 18.92 percent or 21.86 percent).
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