The Cost of Capital for Two Mutually Exclusive Projects That

question 36

Multiple Choice

The cost of capital for two mutually exclusive projects that are being considered is 8%.Project K has an IRR of 20% while Project R's IRR is 15%.The projects have the same NPV at the 8% current cost of capital.However, you believe that money costs and thus your cost of capital will also increase.You also think that the projects will not be funded until the cost of capital 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 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.
• B) You should recommend Project R, because at the new cost of capital it will have the higher NPV.
• C) You should recommend Project K, because at the new cost of capital it will have the higher NPV.
• D) You should recommend Project K because it has the higher IRR and will continue to have the higher IRR even at the new cost of capital.
• E) You should reject both projects because they will both have negative NPVs under the new conditions.

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Definitions:

Investment Portfolio

A collection of investments held by an individual or institution which may include stocks, bonds, real estate, and other financial assets.

Net Income

The amount of earnings left over after all operational, financial, and tax expenses have been subtracted from total revenue; essentially, the company's profit.

Stockholders' Equity

Represents the ownership interest of shareholders in a corporation, calculated as the difference between total assets and total liabilities.

Fair Value

The price that would be received for selling an asset or paid to transfer a liability in an orderly transaction between market participants.