Question

1)   You’re discounting the cash flow projections of a new project (a capital investment). You use your WACC. The result is a positive Net Present Value. Next you compute the IRR of the project using the same cash flows. Assuming you didn’t make an error in your computations, is it possible that the IRR you calculated could, under certain circumstances, be less than your WACC?

Yes

No

2) The reason Working Capital is shown as a cash inflow in the final year (terminal year) of a project is that:

a) When the project stops, inventories are sold and they aren’t replaced with new inventory; the same is true with accounts receivable;

b) When Working Capital rises, it’s good for cash;

c) It’s good for the NPV, so CFOs typically show it in the final year even though technically it’s not proper;

d) None of the above are correct.

3)   When creating cash flow projections for a new capital project, you should use the three components of typical cash flow statements: 1) Operating Cash Flow (Net Income, Depreciation, and the change in Working Capital), 2) the Investment (Capital Expense), and 3) the Financing (proceeds from new borrowings and stock issuances).

True

False

Answer 1

(1) Most capital investment projects involve an initial cash outflow followed by subsequent cash inflows. In such a scenario, a positive NPV would mandatorily mean that the IRR is greater than the discount factor (WACC in this case). This is owing to the fact that the NPV of a cash flow pattern such as described above decreases with an increase in the discount rate. The discount rate increases to equalize the IRR at a point where the NPV of the project becomes zero. Any discount rate above this threshold (the IRR) renders the project NPV negative.

However, if the project involves an initial cash inflow followed by future cash outflows (somewhat similar to a bank borrowing), the NPV increases with an increase in the discount rate. In such a scenario the IRR has to be below the discount rate (the WACC) in this case so as to keep the NPV positive.

Hence, the correct answer is "Yes".

NOTE: Please raise separate queries for answers to the remaining unrelated questions.