As the CEO of a large corporation, you have been given the mandate to select bet
ID: 2785869 • 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.
Explanation / Answer
Answer:
1) On the basis of Cost of the project, one should select the project 2 as the life of project 2 is more than the life of project 1 even though the initial cash out flows are same in both.
2) On the basis of NPV, one should select the project 1 as the NPV of project 1 is greater than the NPV of project 2.
3) On the basis of IRR one should select the project 1 as after 13.5% there is cash inflow over and above the intital cost of project or total cash outflows. Or we can say the IRR of this project is less than the Cost of capital as compare to IRR of project 2 with the cost of capital.
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