- This topic has 2 replies, 2 voices, and was last updated 3 hours ago by
.
- Posts
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.
The project will necessarily have a positive net present value,
when the annual cost of capital is
A More than 25%
B More than 10%
C Between 10% and 25%
D Less than 25%I was not able to understand this question at all.
Can you please explain this questionHere is the solution as well i was not able to understand the solution as well:
Answer A
The graph would be U-shaped with a negative NPV between 10% and
25% and positive NPVs at less than 10% or more than 25%.The project in question has two internal rates of return (IRRs) at 10% and 25%. When a project has multiple IRRs, it indicates that the cash flows change signs more than once, which is typical for non-conventional cash flows.
In this case, the sum of the undiscounted cash flows is positive, meaning that at a 0% discount rate, the NPV is positive. As the cost of capital increases, the NPV decreases.
So:
The NPV is positive when the cost of capital is below 10% and also when it is above 25%. Between 10% and 25%, the NPV is negative. This creates a U-shaped curve when plotting NPV against the cost of capital.
The NPV curve crosses the horizontal axis (NPV = 0) at the two IRRs: 10% and 25%. Therefore, the NPV is positive for costs of capital less than 10% and greater than 25%.
The correct answer is A) more than 25%. This is because, at any cost of capital above 25%, the NPV will be positive, while it will be negative for costs between 10% and 25%.
Thus, the U-shaped graph illustrates that the project is viable at both low and high discount rates, but not in the middle range.
- You must be logged in to reply to this topic.