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Net Present Value (NPV) for Mutually Exclusive Project

Net Present Value (NPV) for Mutually Exclusive Project

Mutually exclusive project is different independent project. For mutually exclusive project, we can accept project A or B or deny both, but we cannot accept both projects.

We may solve mutually exclusive projects using NPV with following two methods:

  1. Compare NPV if NPV(A)>NPV(B), so choose project A
  2. Compute incremental NPV solved via cash flows from project A minus project B, and if incremental NPV > O, so choose project A.

Note: Please note that NPV(A) and NPV(B) are positive values.

Example:

ABC Corporation applies a 12 percent discount rate to two investment opportunities, and we assume both projects are mutually exclusive projects.

Required:

  1. Determine NPVs for both projects.
  2. Determine incremental NPV, you may subtract project 1 cash flows from project 2 cash flows to solve incremental NPV.
  3. Make decision for these projects.

Solution:

  1. NPVs

NPV (project 1) = 70/(1+12%)^1 + 10/(1+12%)^2 – 20 =$ 50,500,000

NPV (project 2) = 15/(1+12%)^1 + 40/(1+12%)^2 – 20 =$ 35,300,000

  1. Incremental NPV

Subtracting project 1 cash flows from project 2 cash flows gives the following results:

Cash flow (Year 0) =-20-(-10)=-10

Cash flow (Year 1)= 70 -15 =55

Cash flow (Year 2) =10-40=-30

Incremental NPV (project 1- project 2) = 55/(1+12%)^1-30/(1+12%)^2 – 10 = $15,200,000

  1. Decision

We can make decisions with following two methods using NPV giving the same answer.

  • Method 1, we compare NPVs

NPV (project 1) > NPV (project 2) or  $50,500,000 > $35,300,000

Because both projects are mutually exclusive projects, so we cannot choose both projects although

they have both positive NPVs. Project 1 is chosen.

  • Method 2, incremental NPV

Incremental NPV (project 1- project 2) = $15,200,000 > 0

Because incremental NPV ( project 1 – project 2) are positive and both projects are mutually                          exclusive projects, so Project 1 is chosen.

Source:

  1. Phnom Penh HR
  2. Mcgraw-Hill – Fundamentals Of Corporate Finance

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