Business Management ABCs

Ranking Mutually Exclusive Projects

The net present value and internal rate of return methods yield the same accept or reject rule in case of independent conventional investments. However, in real business situations there are alternative ways of achieving an objective and, thus, accepting one alternative will mean excluding the other. Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded.

For example, in order to distribute its products a company may decide either to establish its own sales organization or engage outside distributors. The more profitable out of the two alternatives shall be selected. This type of exclusiveness may be referred to as technical exclusiveness. On the other hand, two independent projects may also be mutually exclusive if a financial constraint is imposed. If limited funds are available to accept either project X or project Y, this would be an example of financial exclusiveness or capital rationing. The net present value and internal rate of return methods can give conflicting ranking to mutually exclusive projects. In the case of independent projects ranking is not important since all profitable projects will be accepted. Ranking of projects, however, becomes crucial in the case of mutually exclusive projects. Since the net present value and internal rate of return rules can give conflicting ranking to projects, one cannot remain indifferent as to the choice of the rule.

Both of these rules will give conflicting ranking to the projects under the following conditions:

•The cash flow pattern of the projects may differ. That is, the cash flows of one project may increase over time, while those of others may decrease of vice verso.

•The cash outlays of the projects may differ.

•The projects may have different expected lives.

•Reinvestment Assumption and Modified internal rate of return

•The net present value and internal rate of return rules are sometimes assumed to rest on an underlying implicit assumption about reinvestment of the cash flows generated during the lifetime of the project. It is contented that the source of conflict between the two techniques lies in their different reinvestment rates.

•The internal rate of return method is assumed to imply that the cash flows generated by the project can be reinvestment at its internal rate of return, whereas the net present value method is thought to assume that the cash flows are reinvested at the opportunity cost of capital. Advocates of the reinvestment assumption calculate terminal values of project to prove their point.

•Net present value versus Profitability Index

The net present value and profitability yield same accept or reject rules, because profitability index can be grater than one only when the projects net present value is positive. In case of marginal projects, net present value will be zero and profitability index will be equal to one. But a conflict may arise between the methods if a choice between mutually exclusive projects has to be made.

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