Mutually Exclusive Projects
In capital budgeting, mutually-exclusive projects refer to a set of projects out of which only one project can be selected for investment. A decision to undertake one project from mutually exclusive projects excludes all other projects from consideration.
Unlike independent projects, in which a decision to invest in one project has no bearing on the decision to make investment in another, investment decision in case of mutually exclusive projects is dependent on the relative merit of the projects.
Decision Rule
Capital budgeting decisions are made on the basis of net present value, IRR, payback period and other techniques.
In case of mutually exclusive projects, the project with highest net present value or the highest IRR or the lowest payback period is preferred and a decision to invest in that winning project exclused all other projects from consideration even if they individually have positive NPV or higher IRR than hurdle rate or shorter payback period than the reference period.
On the other hand, there is no such dependence in case of independent projects. Independent (or non-mutually exclusive project) is favorable if the net present value is positive and/or IRR is higher than the hurdle rate and/or the payback period is shorter than a specific reference period.
Example
PQR, Inc. has $40 million at its disposal and the management is considering the following projects for investment. The CFO has prepared the following table for the board of which you are a member.
| Project A | Project B | Project C | |
|---|---|---|---|
| Initial investment | $10,000,000 | $15,000,000 | $15,000,000 |
| Net present value | $20,000,000 | $15,000,000 | $21,000,000 |
| IRR | 25% | 15% | 20% |
The CFO further told the board that the company’s cost of capital is 12%.
What would be your decision if the projects are (a) mutually exclusive, or (b) independent?
Solution
If the project are mutually exclusive, it means the company can select any one of the projects. It can’t invest simultaneously in all the three projects. In such situation, the company should opt for projects generating the maximum net present value i.e. Project B. Although Project A has higher IRR , in case of mutually exclusive projects, a decision based on net present value is theoretically sounder.
If these were independent projects, PQR would invest in all of these projects because they all have positive NPVs and their respective IRRs are higher than the hurdle rate (i.e. the cost of capital, which is 12%).
by Obaidullah Jan, ACA, CFA and last modified on