To illustrate the relevance of these principles in capital budgeting decisions, let's consider a hypothetical firm with a limited capital budget of $10 million, seeking to choose between three investment proposals: Project A, Project B, and Project C.

Project A:

Initial investment: $5 million
Net Present Value (NPV): $10 million
Internal Rate of Return (IRR): 18%

Project B:

Initial investment: $6 million
Net Present Value (NPV): $12 million
Internal Rate of Return (IRR): 20%

Project C:

Initial investment: $4 million
Net Present Value (NPV): $7 million
Internal Rate of Return (IRR): 16%

Graphical illustration:

Plot the initial investments and NPVs of each project on a graph, with the initial investment on the x-axis and the NPV on the y-axis. The graph should show that Project B has the highest NPV but leaves no room for additional investments, while the combination of Projects A and C provides a higher overall NPV for the available capital budget.

Answer rating: 100% (QA)

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