They go for the evaluation of mutually exclusive projects

Project selection, most of the time require a lot of analysis. In the literature there are a variety of financial methods to determine whether to accept or reject a certain project, this is more complicated when they are mutually exclusive, that is, when only one should be chosen. This selection must be made in order to increase shareholder wealth.

This article tries to give us some scopes why we should prefer the NPV to the other methods, such as the Payback, the benefit-cost relation and the Internal Rate of Return (IRR).

1. Why shouldn't we apply the Payback Period for evaluation?

The Payback period is not recommended as a decisive measure in the comparison of projects, since this method is mainly focused on the recovery of investment in the initial periods. A project could have a fairly long Payback period, and it might be a better alternative than one with a shorter Payback period, as it could consider a better amount of benefits after the Payback period.

2. Why not use the B / C ratio?

Analysis by the Benefit-Cost relationship can be sensitive to the selection of the discount rate. For example:

Sensitivity to the selection of the discount rate

Here it is noted that, when you have a rate of return at 2%, you get a B / C ratio slightly higher than 1, that is, feasible, but if the discount rate is changed to 5%, the ratio drops to less. than 1 and it becomes not feasible.

3. Why not prefer the Internal Rate of Return (IRR) method

a) Variability of discount rates in the medium and long term:

IRR simplifies projects to a single figure, which can be used to determine whether a project is viable. If they were all short-term projects, the IRR would probably be a good measure, but in the ever-changing real world, discount rates tend to vary over time. For example, if the rate of return on a US Treasury bill were used as the discount rate. These letters have changed from 1% to 12% in the last 20 years. The IRR would not take these changes into account, so it is not applicable for long-term projects, for a project that has cash flows at different discount rates, or that has uncertain cash flows.

b) Projects with cash flows of different signs:

Another type of project for which the IRR calculation is ineffective is a project with a mix of multiple positive and negative cash flows. For example, consider a project with cash flows like the one shown in the following figure, where there are several sign changes in the flow:

Internal Rate of Return (IRR)

This may be due to the fact that the Safety Department needs to review the Project Safety Plan, which would increase costs, so a single IRR could not be used.

c) Changing market conditions.- If market conditions change, there could be several IRRs.

d) The discount rate of the Project is not known.

As we know, the IRR has to be compared to a discount rate. If the discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value.

4. Why use the VAN?

For NPV, a project is selected in better net monetary terms or for the net financial impact on the company. The advantage of using the VAN method here is that you can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others.

For example: From the flow of the following mutually exclusive projects, A and B, determine, which project to take for sales in PILEY Printing House. With a return rate of 10%.

Internal Rate of Return (IRR)

First, we find the IRR and NPV values.

Internal Rate of Return (IRR)

Note that if we used the IRR criteria, we would select project A, as it has the highest IRR. But nevertheless, we note that project B has better NPV than A.

So, we are in need to decide which mutually exclusive project should be carried out. For this we proceed to make the incremental value (BA) of the projects, which is obtained from the simple subtraction of the flow or (B - A), this gives us a flow (BA) to which we will calculate its NPV.

As the NPV (BA) comes out positive, we will assume that the first or B will be carried out. If it had not been positive, the second or A should be carried out.

If there are more projects, they should be ordered according to the investment, from highest to lowest, working in close pairs, discarded using the incremental NPV. As shown in this article.