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A company is considering a two-year project, which has two annual internal rates of return, namely 10% and 25%. The sum of the undiscounted cash flows is positive.
More than 25%
More than 10%
Between 10% and 25%
Less than 25%Answer is A. I am unable to gain the concept.
I know that cost of capital and npv has indirect relation. If cost of capital increase so NPV decreases but this is totally going above my head. Help me professor.
I also know two IRR are due to non-convectional cashflows.You have not said what the question is asking for, and so I cannot say whether A is the correct answer or not 🙂
However I will explain what is happening.
You will know from my free lectures (and from what you yourself have written), that because there are two IRR’s the graph showing the NPV at different rates of interest will be a curve that crosses the axis (NPV = 0) twice.
The question says that the ‘sum of the undiscounted cash flows is positive’. That means that for interest of 0% (i.e. undiscounted) the NPV is positive.
The NPV at 10% is zero. So if you imagine the graph, the NPV starts off positive and then as the interest rate increases the NPV is falling. At 10% it is zero. The NPV will then become negative but will then start to increase and be zero again at 25%. It will carry on increasing and will be positive again when the interest rate is more than 25%.
“Missing question: the project has positive NPV when the annual cost of capital is:”
Sir I understood. But it is way above my knowledge. How will I able to face such questions?
I was thinking that curve would be inverted U. The ends are touching 10% and 25%.The reason that we know that it is not an inverted ‘u’ is because the NPV is positive at zero %.
Do not worry – by the time you have practiced all of the questions in your Revision Kit you should be easily able to pass the exam. Always there will be some questions in the exam that you will not be sure of – then you just make sure you guess an answer – but not so many as for you not to be able to pass 🙂
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