In what types of situations would capital budgeting decisions be made solely on the basis of a project's net present value (NPV)? Identify potential reasons that might drive higher NPV for a given project. Substantiate your response by providing an example to explain your thought process.
Comparing Mutually Exclusive Projects:
This is the classic situation where sole reliance on NPV is justified. Mutually exclusive projects are those where choosing one automatically prevents the acceptance of the others (e.g., choosing one machine out of three to perform the same task).
Since all cash flows and the time value of money are considered, the project with the highest positive NPV is the one that adds the most value to the firm, maximizing shareholder wealth.
When Other Metrics Are Unreliable or Inconsistent:
Internal Rate of Return (IRR) Conflicts: When comparing mutually exclusive projects, if the NPV and IRR methods give conflicting rankings (often due to differences in project size or timing of cash flows), the NPV rule should always govern the decision.
Project Size Comparison (Profitability Index (PI) is not required): If two projects are of vastly different scales, and a firm's capital constraint is very tight (or if the capital constraint is loose), NPV alone guides the decision. While the Profitability Index (PI) is useful when capital is strictly rationed, in the absence of rationing or when simply selecting the best of a few options, the project that adds the largest absolute dollar value (highest NPV) is preferred.
Absence of Strategic Factors:
When the project is purely financial and offers no significant, unquantifiable strategic benefit (like a new market entry, core technology enhancement, or regulatory compliance) that would outweigh a slightly lower NPV.
A project's NPV is the present value of its expected future cash inflows minus the present value of its expected future cash outflows. Therefore, a higher NPV is driven by factors that either increase the magnitude of the cash flows or decrease the discount rate (cost of capital).
Capital budgeting decisions would be made solely on the basis of a project's Net Present Value (NPV) primarily in situations that meet two key criteria: mutually exclusive projects and uncaptured strategic considerations.
The NPV rule states that a project should be accepted if its NPV is greater than zero, and among multiple acceptable projects, the one with the highest NPV should be chosen. Sole reliance on NPV is appropriate in the following situations:
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