The Cost of Capital for Two Mutually Exclusive Projects That

question 16

Multiple Choice

The cost of capital for two mutually exclusive projects that are being considered is 12%.Project K has an IRR of 20% while Project R's IRR is 15%.The projects have the same NPV at the 12% current cost of capital.Interest rates are currently high.However, you believe that money costs and thus your cost of capital will soon decline.You also think that the projects will not be funded until the cost of capital has decreased, 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 R because it will have both a higher IRR and a higher NPV under the new conditions.
• E) You should reject both projects because they will both have negative NPVs under the new conditions.

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Definitions:

Producer Surplus

The difference between what producers are willing to receive for a good or service and the actual amount they receive, due to the market price being higher.

Fixed Costs

Expenses that do not change with the level of production or sales, such as rent, salaries, and insurance premiums.

Unavoidable Costs

Expenses that a company must pay regardless of its level of production or sales activity, also known as fixed costs.

Long Run Level

A period in economics where all inputs or production factors can be varied, and all costs are variable, allowing for full adjustment to changes.