A firm\'s cost of capital is 12%. The firm has three investment(s) to choose amo
ID: 2629910 • Letter: A
Question
A firm's cost of capital is 12%. The firm has three investment(s) to choose among; the cash flows of each are as follows:
CASH INFLOWS
YEAR A B C
1 $395 ____ $1,241
2 $395 ____ ______
3 $395 ____ ______
4 ______ $1,749 ______
Each investment requires a $1,000 cash outlay, and investments B and C are mutually exclusive.
A.) Which investment(s) should the firm make according to the net present values? Why?
B.) Which investment(s) should the firm make according to the internal rates of return? Why?
C.) If all funds are reinvested at 15 %, which investment(s) should the firm make? Would your answer be different if the reinvestment rate were 12%?
Please answer question in detail and show all work. Thank you:-)
Explanation / Answer
a.
As per NPV, project B should be accepted.
b. IRR of the 3 projects are 9%, 20% and 24% respectively. Thus project C should be accepted as its IRR is highest.
c. We will need to use reinvestment rate as the discounting rate.
As NPV is highest chose Project B. The IRR decision remains same as Project C as no effect on IRR. Overall, one can decide to go with Project C as it has a higher IRR and it gives cashflows in year 1 itself, while B gives 0 in year 1 and 2
if reinvestment rate is 12%, the values remain same as calculated in part a. as the discount rate will be 12% only.
Year A Discounted CF(A) B Discounted CF(B) C Discounted CF(C) 0 -1000 -1000 -1000 -1000 -1000 -1000 1 395 352.6786 0 0 1241 1108.036 2 395 314.8916 0 0 0 0 3 395 281.1532 1749 1244.904 0 0 NPV -51.2766 244.9037 108.0357Related Questions
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