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thereby be the right choice. There is an important reason for this. IRR assumes that all cash flows received during the life of a project are reinvested at the IRR, whereas the NPV method assumes that they are reinvested at the cost of capital. Since the cost of capital is the better proxy for opportunity cost, NPV uses the better proxy, while the IRR uses an unrealistically higher rate as proxy. 10.9A company estimates that an average-risk project has a cost of capital of 8 percent, a below-average risk project has a cost of capital of 6 percent, and an above-average risk project has a cost of capital of 10 percent. Which of the following independent projects should the company accept? Project A has below-average risk and a return of 6.5 percent. Project B has above-average risk and a return of 9 percent. Project C has average risk and a return of 7 percent. Since Project A has below-average risk, it should be accepted if it earns a return of 6 percent, which is the cost of capital for projects of this risk type. Project A earns a return of 6.5 percent and hence should be accepted. Project B is an above-average risk type and only earns 9 percent, while the required rate of return is 10 percent. Thus, this project is a negative NPV project and should be rejected. This is the case with Project C whose return of 7 percent is below the cost of capital of 8 percent and should be rejected. Thus, only Project A is accepted. 10.10Elkridge Construction Company has an overall (composite) cost of capital of 12 percent. This cost of capital reflects the cost of capital for an Elkridge Construction project with average risk. However, the firm takes on projects of various risk levels. The company experience suggests that low-risk projects have a cost of capital of 10 percent and high-risk projects have a cost of capital of 15 percent. Which of the following projects should the company select to maximize shareholder wealth? Project Expected Return Risk 1. Single-family homes 13% Low 2. Multifamily residential 12 Average 3. Commercial 18 High 4. Single-family homes 9 Low 5. Commercial 13 High Project Risk Required Return Expected Return Decision 1. Single-family homes Low 10% 13% Accept 2. Multifamily residential Average 12 12 Accept / Indifferent 3. Commercial High 15 18 Accept