A company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%. The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%. The projects are equally risky. Which of the following statements is CORRECT?
A) Since the smaller project has the higher IRR, the two projects' NPV profiles cannot cross, and the smaller project's NPV will be higher at all positive values of WACC.
B) Since the smaller project has the higher IRR, the two projects' NPV profiles will cross, and the larger project will look better based on the NPV at all positive values of WACC.
C) If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longer-term projects, regardless of how high or low the WACC is.
D) Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger project will have the higher NPV if the WACC is less than the crossover rate.

Question

Quizplus · Accepted Answer

The correct statement is that since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger project will have the higher NPV if the WACC is less than the crossover rate. This means that if the cost of capital is low enough, the larger project will be more valuable despite having a lower IRR. Therefore, the company should consider both the IRR and NPV when choosing between the two projects. Option A is incorrect because even if the smaller project has a higher IRR, the two projects' NPV profiles can cross, and the larger project can have a higher NPV at higher discount rates. Option B is incorrect because the two projects' NPV profiles will cross, and the larger project will have a higher NPV only if the WACC is less than the crossover rate. Option C is incorrect because the company should choose projects based on their NPV, which considers the size, duration, and timing of cash flows, and not just based on their IRR or size.

A Company Is Choosing Between Two Projects