Final answer:
The Net Present Value (NPV) method is the most appropriate for analyzing mutually exclusive investments because it accounts for the time value of money, the scale of projects, and provides a direct measurement of value added to the firm.
Step-by-step explanation:
When comparing two mutually exclusive investments, the most appropriate method of analysis to use is the Net Present Value (NPV) method. Mutually exclusive investments mean that if you choose one, you cannot choose the other, making it critical to accurately assess which one will yield the highest net benefit. NPV is considered the superior technique because it provides a direct measure of the expected increase in value to the firm from undertaking the project. It calculates the present value of the investment's future cash flows by discounting them at the firm's cost of capital and then subtracting the initial investment cost.
Internal Rate of Return (IRR) is another popular tool, but it can be misleading when comparing mutually exclusive projects because it does not take into account the scale of the investment or the reinvestment rate of the cash flows. Profitability Index (PI), just like IRR, does not always provide clear guidance when projects differ in scale. Modified Internal Rate of Return (MIRR) addresses some of the IRR's issues but still doesn't match NPV’s advantage in scale-sensitive decisions.
The Average Accounting Return (AAR) method is not preferred for these kinds of decisions because it ignores the time value of money and cash flow timing, which are crucial in investment decisions.
NPV provides a straightforward answer: the investment with the higher NPV should be preferred as it provides greater value. By using NPV, one can make a sound decision that aligns with the primary financial goal of maximizing shareholder wealth.