Question：BC Co has identified two mutually exclusive projects which have an equivalent effect on the risk profile of the company. Project 1 has a payback period of 2.8 years, an NPV of $17,200, an internal rate of return of 18% and an average accounting rate of return of 19%. Project 2 has a payback period of 3.2 years, an NPV of $15,700, an internal rate of return of 22% and an average accounting rate of return of 21%. The cost of capital is 15%.
Assuming that the directors wish to maximise shareholder wealth and no shortage of capital is expected, which project should the company choose?
A. Project 2 because it has the higher internal rate of return.
B. Project 1 because it has the shorter payback period.
C. Project 1 because it has the higher net present value.
D. Project 2 because it has the higher accounting rate of return.
The correct answer is:Project 1 because it has the higher net present value.
Net present value is the appraisal method to adopt when mutually exclusive projects exist and the aim is to maximise shareholder wealth.