1. A firm has a $100 million capital budge. It is considering two projects that each cost $100 million. Project A has an IRR of 20 percent, and NPV of $9 million, and will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30 percent and an NPV of $50 million. However, the firm’s short-run EPS will be reduced if it accepts Project B, because no revenues will be generated for several years.
a. Should the short-run effects on EPS influence the choice between the two projects?
b. How might situations like this influence a firm’s decision to use payback?
2. If two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project? Why? If the cost of capital declined, would that lead firms to invest more in longer-term projects or shorter-term projects? Would a decline (or an increase) in the WACC cause changes in the IRR ranking of mutually exclusive projects?
3. Discuss the following statement: “If a firm has only independent projects, a constant WACC, and projects with normal cash flows, then the NPV and IRR methods will always lead to identical capital budgeting decisions.” What does this imply about the choice between IRR and NPV? If each of the assumptions above were changed (one by one), how would your answer change?