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:

Profitability Index (PI)

The profitability index is a calculation used to assess the relative profitability of an investment, based on its present value of future cash flows per unit of investment.

Profitability Index (PI)

A calculation that relates the benefits of an investment project to its costs, often used to compare the attractiveness of different projects.

Discount Rate

The rate at which an individual discounts future cash flows to determine their present value, essential in capital budgeting to assess the profitability of investments.

Capital Budgeting

The procedure a company follows to assess possible significant projects or investments.