Area 1: Business Analysis — CPA Practice Question 05

How to approach this question

Recall the rule for mutually exclusive projects: Always follow NPV. NPV assumes reinvestment at the cost of capital (realistic), while IRR assumes reinvestment at the IRR (often unrealistic).

Full Answer

A.Project X, because it maximizes shareholder wealth.✓ Correct

Net Present Value (NPV) measures the absolute dollar value added to the firm. Internal Rate of Return (IRR) measures efficiency/percentage return. For mutually exclusive projects, maximizing total wealth (NPV) is the primary goal. The conflict often arises because Project X might be larger or have cash flows later, which NPV values correctly using WACC.

Common mistakes

Choosing the higher percentage (IRR) thinking it's 'better', failing to distinguish between independent and mutually exclusive projects.

A company is deciding between two mutually exclusive projects. <br/>Project X: NPV = $50,000, IRR = 15%<br/>Project Y: NPV = $40,000, IRR = 22%<br/>The company's Weighted Average Cost of Capital (WACC) is 10%.<br/><br/>Which project should the company accept and why?

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Full Answer

Common mistakes

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