Assume That the Economy Is in a Mild Recession,and as a Result

question 91

Multiple Choice

Assume that the economy is in a mild recession,and as a result interest rates and money costs generally are relatively low.The WACC for two mutually exclusive projects that are being considered is 8%.Project S has an IRR of 20% while Project L's IRR is 15%.The projects have the same NPV at the 8% current WACC.However,you believe that the economy is about to recover,and money costs and thus your WACC will also increase.You also think that the projects will not be funded until the WACC has increased,and their cash flows will not be affected by the change in economic conditions.Under these conditions,which of the following statements is CORRECT?

• A) You should reject both projects because they will both have negative NPVs under the new conditions.
• B) You should delay a decision until you have more information on the projects,even if this means that a competitor might come in and capture this market.
• C) You should recommend Project L,because at the new WACC it will have the higher NPV.
• D) You should recommend Project S,because at the new WACC it will have the higher NPV.
• E) You should recommend Project L because it will have the higher IRR at the new WACC.

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Definitions:

Financial Leverage

The use of borrowed money (debt) to amplify the potential return of an investment or project.

Debt/Equity Ratio

The indicator that compares the role of debt and equity in financing company assets.

Financial Leverage

The use of borrowed money to increase the potential return of an investment, which also increases the risk of loss.