Hi, so far we have evaluated one project at a time. However, sometimes we have to evaluate multiple projects. Let's say you are managing a baseball team and want to sign free agents. Signing a free agent is a project from the team's perspective. As there are many free agents available every winter. The team is evaluating multiple projects at a time when it is dropping at the free agent market. In capital budgeting analysis of multiple projects. You may have multiple independent projects or multiple mutually exclusive projects. Independent projects are the projects whose cash flows are not affected by decisions made about other projects. With multiple independent projects, the acceptance of one project does not eliminate other projects from further consideration. That is, all independent projects can be undertaken if they all are acceptable. On the other hand. Mutually exclusive projects are the ones where the acceptance of one project means the others cannot be accepted. In that sense, mutually exclusive projects compete with one another. Only one project can be undertaken even if they are all acceptable. What decision rules should be used when evaluating multiple projects? If projects are independent, we can just use the same rules we have use For a single project. We accept project as long as their NPVs are positive. Using the payback rule, we'll accept project if the payback period are shorter than the cutoff period. Also, using the IRR rule, we accept project if their IRRs are greater than the discount rate. What about evaluation of mutually exclusive projects? If projects are mutually exclusive, only one project can be purchased. That means, if we use the NPV rule, we should accept the one with the highest NPV. Similarly if we use payback rule, we will choose the product with the shortest payback period. Finally, the IRR rule will suggest that We choose the one with the highest IRR. Now let's consider the following two mutually exclusive projects, A and B. We will get these projects’ NPV and IRR to determine which project to take. As we know, they are mutually exclusive. First, when we apply the discount rate of 10%, the NPV of project A is about $70 while project B has the NPV of about $57. What does the NPV rule say? It says we have to choose the project with the highest NPV. So our choice is project A, because its NPV is greater than that of project B. We have also calculated the IRR too. The IRRs are 13.78% for A and 14.89% for B. Note that both projects are acceptable as the IRRs are both greater and the discount rate is 10%. However, they are mutually exclusive and we can pick only one. The IRR rule says, we need to choose the project with the greatest IRR and project B has a higher IRR than A. Okay, the NPV rule says Project A is better and the IRR rule says Project B is better, so what should we do? Generally, the project with a higher NPV also has higher IRR. Sometimes however, there can be a conflict between NPV rule and IRR rule, just as we saw in the previous example. When projects are independent this is not a problem, because we can just accept all projects. As long as their NPV are greater than zero or their IRRs are greater than the discount rate. But this is a problem when projects are mutually exclusive as we saw earlier. The general principle in capital budgeting is, that whenever there is a conflict between NPV and IRR for mutually exclusive projects. We should always follow the NPV rule. That is because NPV is the dollar amount of value that is created by accepting the project. But IRR is just the rate of return measure. Let's recall the previous example problem. By accepting project A, you can increase your firm value by 70 dollars. If you choose project B, you'll increase your form value by only $57. The question this principle will asked you is this. Do you want to increase your firm value by only $57? When alternatively you can increase it by $70, just because the higher rate or return number looks fancier.
