A firm has the opportunity to invest in a project that is expected to pay an end
ID: 2453122 • Letter: A
Question
A firm has the opportunity to invest in a project that is expected to pay an end-of-year annual return of $2 million for each of the next fifteen years after taxes and expenses. The current cost of the project would be $6 million.Assuming a discount rate of 10%, as the required rate of return and (opportunity) cost of capital (i.e., economic costs of capital): (a) Calculate the present value of the project to the firm. (b) Calculate the net present value of the project. (c) Using the net present value principle, determine whether or not the firm should make the investment. (d) Using the internal rate of return principle, determine whether or not the firm should make the investment.(e) Using the equilibrium market value of the firm principle, determine whether or not the value of the firm would increase if the firm decided to undertake this investment project.
Explanation / Answer
Answer: to the first 4 parts:
a) Present value of the projects cashflow = $2 million * PV annuity factor @10%, 15 years
= $2 million * 7.6061 = $15.2122 million
b) NPV of the projects cashflow = PV of the cashflow - Current cost
= $15.2122 million - $6 million = $9.2122 million
c) As the NPV of the project is positive, the firm should make investment.
d)
The applying the excel function for IRR. i.e. =IRR(Range of cashflows) =IRR(-$6 million,$2 million for 15 years)
The IRR of the project is much higher than required rate of return of 10%. So the firm should invest in the project.
Year Cashflow 0 -6000000 1 2000000 2 2000000 3 2000000 4 2000000 5 2000000 6 2000000 7 2000000 8 2000000 9 2000000 10 2000000 11 2000000 12 2000000 13 2000000 14 2000000 15 2000000 IRR = 32.864%Related Questions
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