Capital budgeting projects that have Internal Rates of Return (IRR) which are lower than the firms cost of capital (WACC) will:Group of answer choicesNegative NPV'sHave positive NPV'sWill be accepted by the firmHave only negative cashflow
Question
Capital budgeting projects that have Internal Rates of Return (IRR) which are lower than the firms cost of capital (WACC) will:Group of answer choicesNegative NPV'sHave positive NPV'sWill be accepted by the firmHave only negative cashflow
Solution
Capital budgeting projects that have Internal Rates of Return (IRR) lower than the firm's cost of capital (WACC) will have negative Net Present Values (NPV).
Here's why:
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The Internal Rate of Return (IRR) is the discount rate that makes the Net Present Value (NPV) of a project zero. In other words, it's the rate at which the present value of future cash inflows equals the initial investment.
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The Weighted Average Cost of Capital (WACC) is the average rate of return a company is expected to pay its investors; the weights are the proportion of each financing source in the company's capital structure.
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If the IRR of a project is less than the WACC, it means the project's return is less than the return required by all investors (debt and equity).
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Therefore, the present value of future cash inflows discounted at the WACC (which is higher than the IRR) will be less than the initial investment, resulting in a negative NPV.
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A negative NPV means the project is not expected to generate a return sufficient to cover the cost of capital, and therefore, it would not typically be accepted by the firm.
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Assume that an investment project’s assumed cash flows are not changed, but the assumed weighted-average cost of capital is reduced. What impact would this have on the net present value (NPV) and the internal rate of return (IRR) of this project? Calculator Time Value Tables Opens in new windowSelect only one option.A.NPV would increase, and IRR would increase.B.NPV would increase, and IRR would not change.Answer B is Correct.If the cost of capital is reduced, the PV factors are increased. This would result in a higher discounted cash inflow each year, resulting in a higher NPV. However, because the project’s assumed cash flows are not changed, the IRR will not change. The IRR is the rate that makes the present value of the expected cash inflows equal the present value of the expected cash outflows.C.NPV would not change, and IRR would not change.D.NPV would decrease, and IRR would increase. Only Display Missed/Flagged Questions Back Next End ReviewHow Can We Help? Opens in new window
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