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When evaluating mutually exclusive capital budgeting projects, the NPV and IRR could conflict with each other...

When evaluating mutually exclusive capital budgeting projects, the NPV and IRR could conflict with each other in the ranking of projects. List and explain three reasons why a conflict could exist. Which technique is best to use in a conflict? Explain.

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Answer #1

There couls exist a conflict between NPV and IRR in case of mutually exclusive projects for the following reasons:

1. Size of the project.

2. Difference in cash flow distribution.

3. NPV and IRR approaches use different reinvestment rate assumptions. Cash flow under the NPV method is reinvested at the WACC and the cash flow under the IRR method is reinvested at the IRR.

Reinvestment at WACC is the superior assumption, so when mutually exclusive projects are evaluated, the NPV approach should be used for the capital budgeting decision. The NPV method is more reliable compared to IRR method in case of mutually exclusive projects.

In case of any query, kindly comment on the solution.

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