A mutually exclusive project is one whose acceptance precludes the acceptance of one or more alternative proposals. For example, if the firm is considering investment in one of two computer systems, acceptance of one system will rule out the acceptance of the other. Two mutually exclusive proposals cannot both be accepted simultaneously. Ranking such projects based on IRR or NPV may give contradictory results. The conflict in rankings will be due to one or a combination of the following differences:
- Scale of investment – cost of projects differ
- Cash flow pattern – timing of cash flows differs. For example, the cash flows of one project increase over time while those of another decrease.
- Project life – projects have unequal economic lives.
It is important to note that one or more of the above constitute a necessary but not sufficient condition for a conflict in rankings. Thus it is possible that mutually exclusive projects could differ on all these dimensions (scale, pattern and life) and still not show any conflict between rankings under the IRR and NPV methods.