IRR : When the cost of capital is less than IRR for...

Question

When the cost of capital is less than IRR for two independent projects, then: (Assume both projects have conventional cash-flows, i.e. one cash outflow at time zero followed by a series of cash inflows):

• A) The NPV and IRR methods will always result in the same accept and reject decisions.

• B) The project with the highest equivalent NPV should be chosen.

• C) The project with the highest IRR should be chosen.

• D) The project with the highest PI should be chosen.

• E) All of the above.

• Answer

  A

• Step-by-step solutions

  Final Answer: A) The NPV and IRR methods will always result in the same accept and reject decisions.

  Explanation

  1. Define Key Concepts

  • NPV (Net Present Value):
    Measures the difference between the present value of cash inflows and outflows over a period of time.

  • IRR (Internal Rate of Return):
    The discount rate that makes the NPV of all cash flows from a project equal to zero.

  • Cost of Capital:
    The required return needed to make a capital budgeting project (e.g., building a new factory) worthwhile.

  2. Understanding the Relationship

  • When the cost of capital is less than the IRR, it means the project is expected to earn more than it costs to finance—indicating profitability.

  • For independent projects with conventional cash flows (i.e., an initial outflow followed by inflows), if the IRR is greater than the cost of capital, the NPV will also be positive.

  • This results in both NPV and IRR methods leading to the same accept/reject decision.

  3. Conclusion

  Since both NPV and IRR evaluate project profitability—and under the condition that the cost of capital is less than the IRR—they will always agree on the decision.

  Therefore, the correct answer is A.