The directors of a company wish to evaluate two mutually exclusive capital investment projects. Both projects have conventional cash flows: an…

The primary objective of investment appraisal for a profit-seeking entity is the maximization of shareholder wealth. The Net Present Value (NPV) method directly supports this objective by calculating the absolute increase in wealth in today's monetary terms that a project is expected to generate. For mutually exclusive projects, selecting the one with the highest positive NPV ensures the company chooses the option that adds the most value. In contrast, both the Internal Rate of Return (IRR) and the Accounting Rate of Return (ARR) are relative measures (percentages), which can lead to incorrect rankings, especially when projects differ in scale or the timing of their cash flows.

A. NPV is theoretically the superior method for investment appraisal as it is directly linked to shareholder wealth maximization; it is not a source of incorrect decisions in this context.

B. The use of accounting profit by ARR, rather than cash flow, is a significant weakness because it ignores the time value of money and can be distorted by accounting policies.

C. The issue of multiple IRRs arises with non-conventional cash flows (e.g., multiple sign changes in the cash flow stream), but the question specifies conventional cash flows, which yield a unique IRR.

1. Drury

C. (2018). Management and Cost Accounting (10th ed.). Cengage Learning. In Chapter 19

Section 19.6

it is explained that "NPV is technically superior to the other discounted cash flow methods... A major weakness of the IRR method is that it can give incorrect rankings for competing projects that have different cash flow patterns." This supports the choice of NPV for mutually exclusive projects.

2. Brealey

R. A.

Myers

S. C.

& Allen

F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education. Chapter 5

"Net Present Value and Other Investment Criteria

" explicitly states

"When you have to choose between mutually exclusive projects

the NPV rule is simple: Calculate the NPV of each project and

from those that are positive

choose the one with the highest NPV." The chapter also details the pitfalls of IRR (the scale and timing problems) when ranking such projects.

3. CIMA (2019). CIMA P2 Advanced Management Accounting Official Study Text. Kaplan Publishing. The chapter on 'Making capital investment decisions' consistently advocates for the NPV method as the superior technique for its direct link to the corporate objective of maximizing shareholder wealth

especially when evaluating mutually exclusive projects (Section on 'NPV and IRR compared').