Question

Mento Mills is considering two mutually exclusive projects. The Amber Project has an internal rate of return (IRR) of 12 percent, while Bukka Project has an IRR of 14 percent. The two projects have very similar risk. Both projects have the same NPV when the cost of capital is 7 percent. Assume each project has an initial cash investment followed by a series of cash returns.

The following are possible statements that can be made about this information:

I. If the cost of capital is 13 percent, Bukka's NPV will be higher than Amber's NPV.

II. If the cost of capital is 9 percent, Bukka's NPV will be higher than Amber's NPV.

III. By increasing the cost of capital, Bukka's NPV will decrease more slowly than Amber's NPV.

IV. Bukka's initial cash investment is less than Amber's initial cash investment.

Which is the best conclusion about these statements?

Select one:

a. Only statement I is correct.

b. Statements I and II are correct.

c. Only statement II is correct.

d. Statements I and III are correct.

e. All the statements are correct.

Answer 1

1. Statement I is true because at any point to the right of the crossover point, Bukka will have a higher NPV than Amber.

2. Statement II is true for the same reason as statement I is true.

3. If we increase the cost of capital, Bukka's NPV will decrease more slowly than Amber's NPV as at the same cost of capital Bukka has a higher IRR.

4. As at the same cost of capital, Bukka has a higher IRR this means that Bukka has given a better result on the initial investment than Amber. We can safely assume that Bukka requires a lower initial outlay than Amber.

Answer - All statements are correct.