Explain how you could apply NPV and IRR criteria for the selection of mutually exclusive project
When evaluating mutually exclusive projects, the Net Present Value (NPV) and Internal Rate of Return (IRR) criteria can be useful in determining which project is more financially viable.
To apply the NPV criteria, follow these steps:
1. Estimate the cash flows generated by each project over its lifespan. This includes the initial investment, expected revenue, and any expenses or savings.
2. Determine the discount rate, which represents the minimum acceptable rate of return or the cost of capital. This rate reflects the time value of money and risk associated with the project.
3. Calculate the present value of each project's cash flows by discounting them back to their present value using the discount rate. The formula for NPV is: NPV = CF0 + CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n
where CF0 is the cash flow at time 0 (the initial investment) and CF1, CF2, etc., represent the cash flows in subsequent periods, and r is the discount rate.
4. Compare the NPVs of the projects. The project with a higher NPV is considered more financially desirable, as it indicates a higher net gain in value.
To apply the IRR criteria, follow these steps:
1. Again, estimate the cash flows for each project over its lifespan.
2. Calculate the IRR for each project. The IRR is the discount rate that makes the NPV of the project equal to zero.
3. Compare the IRRs of the projects. The project with a higher IRR is considered more financially desirable, as it indicates a higher rate of return.
However, it's important to note that NPV and IRR have their limitations. NPV assumes the ability to reinvest cash flows at the discount rate, which may not always be feasible, while IRR may have multiple solutions if there are unconventional cash flows. Therefore, it is suggested to use both criteria in conjunction with other financial analysis techniques to make a well-informed decision.