A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the following independent projects should the company accept?
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A. B. C. D. E.Explanation
This is the only project with either a positive NPV or an IRR which exceeds the cost of capital.
To determine which project a company should accept, we need to compare the projects' expected returns to the company's weighted average cost of capital (WACC). The WACC represents the average rate of return the company needs to generate to satisfy its investors.
Let's analyze each project and compare their returns to the company's WACC of 10 percent:
A. Project C requires an up-front expenditure of $1,000,000 and generates a positive internal rate of return (IRR) of 9.7 percent. The IRR represents the discount rate at which the project's net present value (NPV) becomes zero. Since the IRR (9.7 percent) is lower than the company's WACC (10 percent), the project's return is lower than the required rate. Therefore, we should not accept Project C.
B. Project D has an internal rate of return (IRR) of 9.5 percent. Similar to Project C, the IRR of Project D (9.5 percent) is lower than the company's WACC (10 percent). Thus, Project D also does not meet the required return rate and should not be accepted.
C. None of the projects should be accepted. This answer suggests that neither Project C nor Project D should be accepted. However, we still need to evaluate the other projects before concluding.
D. Project B has a modified internal rate of return (MIRR) of 9.5 percent. The MIRR is a variation of the IRR that accounts for the reinvestment rate of the project's cash flows. Like the previous projects, Project B's MIRR (9.5 percent) is below the company's WACC (10 percent), indicating that it does not meet the required return rate and should not be accepted.
E. Project A requires an up-front expenditure of $1,000,000 and generates a net present value (NPV) of $3,200. The NPV represents the present value of a project's expected cash flows, discounted at the company's WACC. A positive NPV suggests that the project's returns exceed the required rate of return. In this case, Project A's NPV of $3,200 indicates that it generates returns higher than the company's WACC. Therefore, Project A should be accepted.
Based on the detailed analysis, the company should accept Project A as it generates returns above the company's WACC. The correct answer is E. Project A requires an up-front expenditure of $1,000,000 and generates a net present value of $3,200.