Question

Consider the following cash flows for two mutually exclusive capital investment projects. The required rate of return is 15%. Use this

Year         Project A Cash Flow        Project B Cash Flow

0                         -$40,000                           -$30,000

1                              12,000                            9,000

2                              12,000                             9,000

3                              12,000                             9,000

4                              10,800      8,100

5                              10,800                              8,100

6                              5,400      8,100

9. Which of the following statements is true concerning projects A and B?

a) Both NPV and IRR lead to the same investment decision.
b) Due to time disparity, IRR indicates that project A should be accepted and NPV indicates that project B should be accepted.
c) Due to time disparity, IRR indicates that project B should be accepted and NPV indicates that project A should be accepted.
d) Due to size disparity, IRR indicates that project A should be accepted and NPV indicates that project B should be accepted.
e) Due to size disparity, IRR indicates that project B should be accepted and NPV indicates that project A should be accepted.

10. Which of the following cash flows are not considered in the calculation of the initial outlay for a capital investment proposal?
a) increase in net working capital.
b) cost of issuing new bonds to finance the new project.
c) purchase price of asset
d) installation costs.
e) proceeds from selling an old asset which is being replaced by a new asset.

Answer 1

9. a

Project B has the higher NPV and also the higher IRR. Hence project B should be accepted as per both rules. Other options hence are incorrect.

Year	Project A	Project B
0	-40000	-30000
1	12000	9000
2	12000	9000
3	12000	9000
4	10800	8100
5	10800	8100
6	5400	8100
NPV	1277.71	2709.21
IRR	16.28%	18.38%

10: b

The cost of issuing new bonds is included in the WACC. Hence explicit cash flows are not considered.Other costs are considered in determination of initial outlay.