As the CEO of a large corporation, you have been given the mandate to select bet
ID: 2780642 • Letter: A
Question
As the CEO of a large corporation, you have been given the mandate to select between two mutually exclusive projects which both cost $1.5Million. Project 1 is a short term project and has most of its cash flows in the early years while project 2 is long-term and realizes its cash flows in the distant future. The NPV and IRR of the projects are as follows:
Project 1
Project 2
NPV
$85,500
$55,000
IRR
13.5%
18%
The cost of capital is 14%. Considering the timing of the cash flows and the similar size of the project, what recommendation would you make to your board of directors as it relates to the two projects? State all your assumptions.
Project 1
Project 2
NPV
$85,500
$55,000
IRR
13.5%
18%
Explanation / Answer
As per information of the question, project 1 and project 2 are mutually exclusive projects.
Project 2 should be accepted while project 1 should be rejected due to following reasons;
1. Project 2 has higher IRR in compare to its cost of capital. As per question it is clear that cost of capital is 14% whereas IRR of project 2 is 18%. Thus project 2 is better option.
2. It is clear that NPV of project 2 is lower than project 1 but IRR of project 1 is low than minimum required cost of capital 14%. That is why project 1 cannot be accepted.
3. Project 2 is a long-term project hence it is clear that this project will generate long-term returns in compare to project 1. So Project 2 is better option because this project have positive NPV and higher IRR as well.
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