A Note on the Comparison of NPV Profiles of Mutually Exclusive Projects

Abstract

One of the basic tenets of modern finance is that an asset’s required return depends on that asset’s risk. Hence, a project’s cost of capital should be matched with the riskiness of that project. From this standpoint, one may conclude that the standard textbook treatment of NPV profiles is restricted to the case where the projects being compared have the same risk and, therefore, have the same discount rate. When the same discount rate is inappropriately applied to different projects, the usual comparison of NPV profiles can be misleading. It is when possible differences in project risk and associated cost of capital are explicitly considered, that NPV profiles can become more useful in the comparative evaluation of mutually exclusive projects.

Keywords: NPV, IRR, Capital Budgeting, Discount Rate, Project Cost of Capital

JEL Classification: G11, G31, G30