The WACC for two mutually exclusive projects that are being considered is 8%. Pr

Question

The WACC for two mutually exclusive projects that are being considered is 8%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?

a. You should recommend Project K, because at the new WACC it will have the higher NPV. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should reject both projects because they will both have negative NPVs under the new conditions. d. You should recommend Project R, because at the new WACC it will have the higher NPV. e. You should recommend Project K because it has the higher IRR and will continue to have the higher IRR even at the new WACC.

Explanation / Answer

e. The IRR refers to that point where the NPV of a project becomes zero. This occurs when the cost of capital matches the IRR. A higher IRR is generally always preferred, because, other aspects remaining constant, it shows a flexibility to accomadate a higher cost of capital, which is necessary in this case. Choosing Project K by the higher NPV alone would be inappropriate, considering we have no information on the prospective investment that has gone into both Projects K and R. It is possible that the investment in K would be much higher than that in R and that the relative return would be lower. Thus, in this case, we can consider taking Project K on the basis of the IRR.

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