Mutually Exclusive Investments
Mutually exclusive investments are investment projects that compete with each other in such a way that the acceptance of one investment excludes the acceptance of the other(s). In other words, if you choose one, you can’t choose the other.
This happens when a business has a limited amount of capital and must decide between two or more projects that can’t be undertaken simultaneously. The company must analyze and decide which project will provide the greatest return or be the best use of the company’s resources.
For instance, a company might be considering investing in a new manufacturing plant in either City A or City B. If the company has enough resources to build only one plant, the investments are considered mutually exclusive – choosing to build the plant in City A excludes the possibility of building the plant in City B, and vice versa.
When evaluating mutually exclusive investments, companies typically use capital budgeting techniques like Net Present Value (NPV), Internal Rate of Return (IRR), or Payback Period to determine which project would provide the greatest benefit.
Example of Mutually Exclusive Investments
Imagine you’re the CEO of a technology firm, TechnoFirm, and you have $2 million to invest in a new project. There are two promising projects on the table, but you only have enough resources to invest in one of them.
- Project A involves developing a new computer software. The projected return on investment for this project is $2.5 million over three years.
- Project B involves developing a mobile application. The projected return on investment for this project is $3 million over five years.
Projects A and B are mutually exclusive investments because choosing one excludes the possibility of choosing the other due to resource constraints.
To decide between these two projects, you might consider factors like the timeframe of the returns, the risk involved with each project, the strategic fit with your company’s objectives, and the net present value (NPV) or internal rate of return (IRR) of each project.
After careful analysis, if you find that Project B has a higher NPV or IRR, and you’re comfortable with the longer timeframe and associated risks, you might choose Project B, even though it means you cannot proceed with Project A. Thus, the two projects are mutually exclusive.