4 a. If the NPV (Net Present Value) of a project is positive, then the project\'

Question

4

a.

If the NPV (Net Present Value) of a project is positive, then the project's IRR (Internal Rate of Return) ____________ the required rate of return/cost of capital of the project.

cannot be determined without actual cash flows

could be greater than or less than

must be less than

none of the above.

V. must be greater than

  

b.

Consider the following two projects:

Time         Cash Flows

                A                      B

0          -$4,000               -$4,000

1           $2,003               $0

2            $2,003               $0

3            $2,003               $0

4           $2,003               $10,736

Assuming a 14 percent discount rate, which project would you prefer?

Hint: Use NPV method

Project A, because it has a higher IRR

Project B, because it has a higher IRR

III. Project A, because it has a higher NPV
                     
      

Project B, because it has a higher NPV

None of the above

I.

cannot be determined without actual cash flows

II.

could be greater than or less than

III.

must be less than

IV.

none of the above.

V. must be greater than

  

b.

Consider the following two projects:

Time         Cash Flows

                A                      B

0          -$4,000               -$4,000

1           $2,003               $0

2            $2,003               $0

3            $2,003               $0

4           $2,003               $10,736

Assuming a 14 percent discount rate, which project would you prefer?

Hint: Use NPV method

I.

Project A, because it has a higher IRR

II.

Project B, because it has a higher IRR

III. Project A, because it has a higher NPV
                     
      

IV.

Project B, because it has a higher NPV

V.

None of the above

Explanation / Answer

a.

Option ii.

IRR and NPV need not lead to the same decision. Even when NPV is positive IRR can be either greater or less than cost of capital. This is because they both are different measures, while NPV is the cashflow, IRR is the discount rate.

b.

NPV is calculated by discounting the cashflows

PV = C/(1+r)^n

C - Cashflow

r - Discount rate

n - years to the cashflow

Project A:

NPV = -4000 + 2003/(1+0.14)^1 + 2003/(1+0.14)^2 + 2003/(1+0.14)^3 + 2003/(1+0.14)^4 = $1836.17

Project B:

NPV = -4000 + 10736/(1+0.14)^4 = $2356.57

Option iV.

Choose project B, because it has a higher NPV

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