   Chapter 11, Problem 5Q Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Solutions

Chapter
Section Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

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? Explain.

Summary Introduction

To explain: Impact of the cost of capital on the longer term or the shorter term project and whether a decline in WACC would cause changes in the IRR ranking of mutually exclusive projects.

Introduction:

Mutually Exclusive Projects:

It refers to the group of projects in which, if one project is accepted, it will automatically imply the rejection of rest. It refers to those projects for which investment cannot be made together.

Weighted Average Cost of Capital (WACC):

It is the discounted rate that has been calculated by the company on the basis of which the present values of cash outflows and inflows are calculated under capital budgeting.

Internal Rate of Return (IRR):

It refers to the rate of return that is computed by the company to make a decision regarding the selection of a project for investment. This rate provides the basis for selection of projects with lower cost of capital and rejection of project with higher cost of capital.

Explanation
• If two mutually exclusive projects were being compared, a high cost of capital would favor the shorter term project as the Net Present Value (NPV) of long term project includes high amount of investment with high amount of cash flows yearly in comparison to short term projects. Little increase in the rate of cost of capital will decrease the higher amount of cash inflows.
• If the cost of capital decreases, the company will move more towards longer term project as there would be more returns for longer period of time.
• A decline in WACC would not cause any change in the IRR ranking of mutually exclusive projects if there is an increase or decrease in WACC of all projects are same. But it may cause the change in IRR ranking for mutually exclusive projects if there is a decline in cost of capital of one project than other.

Reasons for a high cost of capital favoring the shorter term project instead of longer term project are,

• Since, NPV uses the discounted method to calculate cash flows; the higher amount will have higher effect due to change in the cost of capital. So, high cost of capital will result in greater decrease in cash inflows from longer term projects.
• Since, long term projects will have cash flows for longer period of time, the change in WACC will have effect on all the cash flows of that period. So, higher the period, higher will be the effect on cash flows due to WACC...

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