Which of the following statements is correct?
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A. B. C. D. E.E
This statement reflects exactly the difference between the NPV and IRR methods.
Let's go through each statement and evaluate its correctness:
A. If you are choosing between two projects which have the same life, and if their NPV profiles cross, then the smaller project will probably be the one with the steeper NPV profile.
This statement is incorrect. When two projects have the same life and their net present value (NPV) profiles cross, it means that at some discount rates, one project has a higher NPV than the other, while at other discount rates, the situation is reversed. The steeper NPV profile does not necessarily indicate the smaller project. The size of the project is not related to the shape of its NPV profile.
B. If the cost of capital is relatively high, this will favor larger, longer-term projects over smaller, shorter-term alternatives because it is good to earn high rates on larger amounts over longer periods.
This statement is incorrect. The cost of capital refers to the required rate of return for an investment, which takes into account the risk and opportunity cost of investing. A higher cost of capital makes it more difficult for projects to generate returns that exceed this rate. In such a case, smaller, shorter-term projects may be favored as they can generate returns more quickly and have less exposure to risks over longer periods.
C. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV profiles, an NPV/IRR conflict will not occur.
This statement is correct. The crossover rate is the discount rate at which the NPV profiles of two mutually exclusive projects intersect. If the cost of capital is lower than the crossover rate, it means that the project's NPV will be positive for all discount rates below the crossover rate. In this situation, an NPV/IRR conflict, where different projects have conflicting rankings based on net present value and internal rate of return, is unlikely to occur.
D. Because discounted payback takes account of the cost of capital, a project's discounted payback is normally shorter than its regular payback.
This statement is correct. The discounted payback period takes into account the time value of money by discounting cash flows back to their present values. Since the discounted payback period considers the cost of capital, it will generally be shorter than the regular payback period, which does not consider the time value of money.
E. The NPV and IRR methods use the same basic equation, but in the NPV method, the discount rate is specified and the equation is solved for NPV, while in the IRR method, the NPV is set equal to zero, and the discount rate is found.
This statement is correct. Both the net present value (NPV) and internal rate of return (IRR) methods are used to evaluate investment projects. The NPV method calculates the present value of cash inflows and outflows using a specified discount rate, and if the NPV is positive, it indicates a desirable investment. On the other hand, the IRR is the discount rate that makes the NPV equal to zero. In the IRR method, the NPV equation is rearranged to find the discount rate that satisfies this condition.
To summarize: