When evaluating mutually exclusive projects, which rule best guides decision-making?

When evaluating mutually exclusive projects, which rule best guides decision-making?

• A. Choose the project with the highest NPV.
• B. Choose the project with the highest NPV; IRR alone can be misleading for non-standard cash flows.
• C. Choose the project with the highest IRR.
• D. Choose the project with the shortest payback period.

Answer: (B)

When evaluating mutually exclusive projects, the goal is to maximize value for the firm, so the best guide is to choose the project with the highest net present value. NPV measures how much value a project adds by discounting all expected cash flows at the firm’s required return and summing them up. It captures both the timing and size of cash flows, so it directly reflects the impact on shareholder wealth, regardless of project scale or timing differences. IRR can be misleading in this context, especially with non-standard cash flows. When cash flows don’t follow a normal pattern—such as multiple sign changes or additional investments later—the project can have multiple IRRs or an IRR that looks attractive but actually adds less value when assessed at the true cost of capital. IRR also relies on the assumption that interim cash flows can be reinvested at the IRR itself, which is often unrealistic. Because of these issues, ranking projects by IRR alone can lead to selecting the wrong option.

When evaluating mutually exclusive projects, the goal is to maximize value for the firm, so the best guide is to choose the project with the highest net present value. NPV measures how much value a project adds by discounting all expected cash flows at the firm’s required return and summing them up. It captures both the timing and size of cash flows, so it directly reflects the impact on shareholder wealth, regardless of project scale or timing differences.

IRR can be misleading in this context, especially with non-standard cash flows. When cash flows don’t follow a normal pattern—such as multiple sign changes or additional investments later—the project can have multiple IRRs or an IRR that looks attractive but actually adds less value when assessed at the true cost of capital. IRR also relies on the assumption that interim cash flows can be reinvested at the IRR itself, which is often unrealistic. Because of these issues, ranking projects by IRR alone can lead to selecting the wrong option.