9. Johnson Company spends $2709 for an investment that returns $2,000 the first
ID: 2501015 • Letter: 9
Question
9. Johnson Company spends $2709 for an investment that returns $2,000 the first year, and $1,000 the second year. Is the IRR also 8%?
10. In practice, it seems that the NPV method is used more often than IRR. Why do you think this would be the case?
11. Johnson Company calculated the NPV of an investment, and using a discount rate of 10%, the NPV was zero. Does this mean that the investment is unacceptable? What does it mean?
12. Suppose Johnson calculated the NPV and found that the NPV was $3,400 using a discount rate of 6%. Do you think the internal rate of return in this case would be a. less than 6% or b. greater than 6% or c. exactly equal to 6%?
13. Describe what is meant by the following terms:
a. cost of capital
b. hurdle rate
c. the time value of money
14. What is capital rationing?
Explanation / Answer
10.Its popularity is probably a direct result of its reporting simplicity. The NPV method is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates, or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value.
12. exactly equal to 6%
13.A) Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, thecost of capital is the rate of return required to persuade the investor to make a given investment.
B)
The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, the riskier the project, the higher the hurdle rate.
In the hedge fund world, hurdle rate refers to the rate of return that the fund manager must beat before collecting incentive fees.
C) Time Value of Money - TVM' The idea that money available at the presenttime is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.
14. Capital Rationing' The act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget.
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