Question

1. In terms of evaluating mutually exclusive projects, the Internal Rate of Return (IRR) method may mistakenly favor investment proposals with:

a: Short useful lives.

b: Long useful lives.

c: Moderate cash flow returns

d: Large residual values

e: Large initial investment.

2. When the internal rate of return (IRR) method and the net present value (NPV) method do not yield the same recommendation for the same investment project, the projectt-selection decision should normally be based on:

a: IRR, because all reinvestment of funds occurs at the rate of the cost of capital and because it takes into consideration the relative size of the initial investment

b: NPV, because it takes into consideration the relative size of the initial investment

c: IRR, because all reinvestment of funds occurs at the discount rate that will make the NPV of the project equal to zero.

d: NPV, because all reinvestment of funds occurs at the discount rate that will make the NPV of the project equal to zero.

e: IRR, because all reinvestment of funds occurs at the rate the project generates and because it takes into consideration the relative size of the initial investment.

Answer 1

1. In terms of evaluating mutually exclusive projects, The IRR method will mistakenly favor investments proposal with:

b. Long useful lives, because it is the nature of IRR method that it will take into consideration Time value of money concept. The projects with longer useful lives will simply result in higher cash flows, which ultimately result in higher rate of return and selection of project due to higher IRR.

2. When the internal rate of return (IRR) method and the net present value (NPV) method do not yield the same recommendation for the same investment project, the project-selection decision should normally be based on:

d. NPV, because all reinvestment of funds occurs at the discount rate that will make the NPV of the project equal to zero. The NPV method helps in identifying those projects that can make a positive contribution to the value of the firm. The re-investment rate is the rate at which the periodic cash inflows are reinvested. This is the rate that is used to discount future cash flows to the present value in the NPV method. The inherent assumption in NPV method is that the cash flows will be reinvested at the same discount rate at which they are discounted, thus resulting in 0 NPV of the project.