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Dear John,
When calculating NPV with capital rationing and two projects are mutually exclusive how do we know which project to pick? Do we just simply pick the one with higher profit index?
No – you have to try both alternatives.
It is a bit difficult to explain in words here, so I will try with a simply illustration .
Suppose you calculate the NPV per $ invested and the project are ranked in this order:
B then A then D then C.
Suppose also that A and D are mutually exclusive.So the two possibilities are B then A then C
or: B then D then CYou need to calculate the total NPV for both of them and then choose which of the two is the best (highest total NPV).
I hope that makes sense 🙂
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