Assume that the economy is enjoying a strong boom,and as a result interest rates and money costs generally are relatively high.The WACC for two mutually exclusive projects that are being considered is 12%.Project S has an IRR of 20% while Project L's IRR is 15%.The projects have the same NPV at the 12% current WACC.However,you believe that the economy will soon fall into a mild recession,and money costs and thus your WACC will soon decline.You also think that the projects will not be funded until the WACC has decreased,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 reject both projects because they will both have negative NPVs under the new conditions.
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 recommend Project L,because at the new WACC it will have the higher NPV.
D) You should recommend Project S,because at the new WACC it will have the higher NPV.
E) You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.

Question

Quizplus · Accepted Answer

Project L should be recommended because as the WACC decreases, the NPV of projects with lower IRRs (closer to the original WACC) tends to increase more than that of projects with higher IRRs. Since both projects have the same NPV at the current WACC of 12%, and Project L has a lower IRR (15%) compared to Project S (20%), Project L's NPV will benefit more from a decrease in WACC, making it the preferable choice under the expected conditions.

Assume That the Economy Is Enjoying a Strong Boom,and as a Result