US CMA Part 2 · Chapter 8 · Question 9 of 15
Two mutually exclusive projects of the same size and life are being evaluated. Project M has the higher NPV at the firm's cost of capital, while Project N has the higher IRR. Which project should be selected, and why?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: D) Project M, because NPV measures the increase in shareholder wealth and assumes reinvestment at the cost of capital
Explanation
When NPV and IRR rank mutually exclusive projects differently (because of differences in timing of cash flows or scale), the NPV ranking should be followed. NPV measures the absolute increase in wealth and implicitly assumes reinvestment at the cost of capital, whereas IRR assumes reinvestment at the IRR itself, which is often unrealistic.
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