Question

A company estimates that the appropriate discount rate (i.e., the cost of capital) for Project A, Project B, Project C and Project D described below is 10 percent. Assuming that the projects are independent, which project(s) should the company accept?
a. Project A requires an up-front expenditure of $1,000,000 and generates a net present value of $3,200.
b. Project B has an internal rate of return of 9.5 percent.
c. Project C requires an up-front expenditure of $1,000,000 and has a profitability index of 0.85
d. Project D requires an up-front expenditure of $200,000 and generates a net present value of negative $200
e. None of the projects above should be accepted.

Answer 1

Answer:

a. Project A requires an up-front expenditure of $1,000,000 and generates a net present value of $3,200.

Explanation:

a.

The company should accept project A because it provides a positive net present value of $3,200 that is the highest among all the projects.

b.

When the IRR of a project is lower than the required rate of return of the project, it will generate the negative net present value because at IRR the net present value of the project will be zero and at a higher rate than IRR it will be negative.

c.

The project with a profitability index of less than 1 generates a negative NPV because the present value of future cash flows is less than the initial cash outflow.

d.

Project D also generates a positive net present value but it is lower than project A. So, after comparing the results we will choose the project with higher NPV.