Which of the following statements is correct?
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A. B. C. D. E.C
The two conditions which can cause NPV profiles to cross, and thus conflicts to arise between NPV and IRR: 1) when project size differences exists, or 2) when timing differences exist.
Let's go through each statement and evaluate its correctness:
A. Only if one attempts to calculate MIRRs does one have to worry about multiple IRRs. This statement is incorrect. MIRR (Modified Internal Rate of Return) is a method used to address the potential issue of multiple internal rates of return (IRRs) in a project. Multiple IRRs can occur when the cash flows of a project change signs more than once. MIRR calculates a single rate of return by assuming that cash inflows are reinvested at a specified rate of return. However, even without calculating MIRRs, one may still encounter projects with multiple IRRs, especially when there are unconventional cash flow patterns.
B. The discounted payback is generally shorter than the regular payback. This statement is generally true. The payback period measures the time it takes for an investment to recover its initial cost. The regular payback period calculates the time in which the cumulative cash flows equal or exceed the initial investment. On the other hand, the discounted payback period considers the time required to recover the initial investment based on discounted cash flows using a predetermined discount rate. Since the discounted payback considers the time value of money, it tends to be longer than the regular payback period.
C. The NPV and IRR methods can lead to conflicting accept/reject decisions only if (1) mutually exclusive projects are being evaluated and (2) if the projects' NPV profiles cross at a rate less than the firm's cost of capital. This statement is correct. The net present value (NPV) and internal rate of return (IRR) are two commonly used capital budgeting techniques. Normally, these methods will provide the same accept/reject decision for independent projects. However, when evaluating mutually exclusive projects (where only one project can be chosen), conflicts can arise. If the NPV profiles of the projects cross at a rate less than the firm's cost of capital, the NPV method will favor the project with the higher NPV, while the IRR method may favor the project with the higher IRR. This is because the IRR assumes that cash flows are reinvested at the project's own rate of return, which may not reflect the firm's cost of capital.
D. The NPV and IRR methods can lead to conflicting accept/reject decisions only if (1) mutually exclusive projects are being evaluated and (2) if the projects' NPV profiles cross at a rate greater than the firm's cost of capital. This statement is incorrect. As explained in the previous statement, conflicts between the NPV and IRR methods can occur when evaluating mutually exclusive projects, but the projects' NPV profiles should cross at a rate less than the firm's cost of capital, not greater.
E. Any type of project might have multiple rates of return if the IRR is sufficiently high. This statement is incorrect. While it is true that projects with unconventional cash flow patterns can potentially have multiple IRRs, the existence of multiple IRRs is not determined solely by the IRR being sufficiently high. Multiple IRRs arise when there are changes in cash flow direction (negative to positive or positive to negative) more than once. These changes can occur in both high and low IRR scenarios.
In summary:
Please note that this response is based on general financial principles and does not take into account any specific information or updates beyond my knowledge cutoff in September 2021.