Question

Which one of the following statements is correct? Assume cash flows are conventional. Explain how you got your answer A. If two projects are mutually exclusive, you should select the project with the shortest payback period. B. The profitability index will be greater than 1.0 when the net present value is negative. C. Projects with conventional cash flows may sometimes have multiple internal rates of return. D. If the required return exceeds IRR, the profitability index will be less than 1.0. E. When the internal rate of return is above than the required return, the net present value is negative.

Answer 1

A. If two projects are mutually exclusive, you should select the project with highest NPV. Hence, A is incorrect.

Net Present value = Present value of Cash Inflows – Present Value of Cash Outflows

Profitability Index = Present Value of Cash Inflows/Initial Investment

Profitability Index is greater than 1, when NPV is Positive and vice versa

Hence, B is incorrect

C. Projects with conventional cash flows will have one IRR, hence c is incorrect

IRR is the return that a project provides. If the required return is less than IRR i.e. project provides higher return than required return, NPV will be positive and Profitability Index will be greater than 1 and vice versa

Hence, the correct statement is D. If the required return exceeds IRR, the profitability index will be less than 1.0.