Answer:
Comment for statement A - The firm must still compare the IRR with the opportunity cost of capital when using the IRR rule. Therefore, even with the IRR method, the appropriate discount rate must still be specified.
Comment for statement B - There should be a higher discount rate on risky cash flows than the rate used to discount less risky cash flows.
Making use of the payback rule is equivalent to using the NPV rule with a zero discount rate for cash flows before the payback period and an infinite discount rate for cash flows thereafter.
Explanation:
a)
“I like the IRR rule. I can use it to rank projects without having to specify a discount rate”
The firm must still compare the IRR with the opportunity cost of capital when using the IRR rule. Therefore, even with the IRR method, the appropriate discount rate must still be specified.
b.
“I like the payback rule. As long as the minimum payback period is short, the rule makes sure that the company takes no borderline projects. That reduces risk”
There should be a higher discount rate on risky cash flows than the rate used to discount less risky cash flows.
Making use of the payback rule is equivalent to using the NPV rule with a zero discount rate for cash flows before the payback period and an infinite discount rate for cash flows thereafter.
