A firm has the following investment alternatives. Each one lasts a year. Investm
ID: 2669626 • Letter: A
Question
A firm has the following investment alternatives. Each one lasts a year.Investment A
B
C
Cash inflow $1,150
$560
$600
Cash outflow $1,000
$500
$500
The firm's cost of capital is 7 percent. A and B are mutually exclusive, and B and C are mutually exclusive.
What is the net present value of investment A? Investment B? Investment C?
What is the internal rate on investment A? Investment B? Investment C?
Which investment(s) should the firm make? Why?
If the firm had unlimited sources of funds, which investment(s) should it make? Why?
If there were another alternative, investment D, with an internal rate of return of 6 percent, would that alter your anser to question (d)? Why?
If the firm's cost of capital rose to 10 percent, what effect would that have on investment A's internal rate of return?
Explanation / Answer
NPV = PV of cash inflows - PV of cash outflows NPV of A = 1,150*PVIF(1,7%) - 1,000 = 1,150*0.9345 - 1,000 = $75 NPV of B = 560*PVIF(1,7%) - 500 = 560*0.9345 - 500 = $23 NPV of C = 600*PVIF(1,7%) - 500 = 600*0.9345 - 500 = $60 IRR is the discount rate at which PV of cash inflows = PV of cash outflows IRR of A = 1,150*PVIF(1,k) = 1,000 PVIF(1,k) = 1000/1150= 0.869 refering PVIF table in 1 year, k= 16% IRR = 16% IRR of B = 560*PVIF(1,k) = 500 PVIF(1,k) = 500/560= 0.893 refering PVIF table in 1 year, k= 12% IRR = 12% IRR of C = 600*PVIF(1,k) - 500 PVIF(1,k) = 500/600= 0.833 refering PVIF table in 1 year, k= 20% IRR = 20% Decision : According to NPV: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest positive NPV According to IRR: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest IRR more than cost of capital. If the firm has unlimited resouces, it can accept both projects A and C. This is because, both are projects are giving positive NPVs and are independent. Project D with IRR of 6% will not alter the answer. Among NPV and IRR decision will be taken based on NPV which satisfies wealth maximisation objective of Financial Management. If the cost of capital of A is 10%, it will not affect the IRR and decision will be same as IRR is more than k. NPV of B = 560*PVIF(1,7%) - 500 = 560*0.9345 - 500 = $23 NPV of C = 600*PVIF(1,7%) - 500 = 600*0.9345 - 500 = $60 IRR is the discount rate at which PV of cash inflows = PV of cash outflows IRR of A = 1,150*PVIF(1,k) = 1,000 PVIF(1,k) = 1000/1150= 0.869 refering PVIF table in 1 year, k= 16% IRR = 16% IRR of B = 560*PVIF(1,k) = 500 PVIF(1,k) = 500/560= 0.893 refering PVIF table in 1 year, k= 12% IRR = 12% IRR of C = 600*PVIF(1,k) - 500 PVIF(1,k) = 500/600= 0.833 refering PVIF table in 1 year, k= 20% IRR = 20% Decision : According to NPV: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest positive NPV According to IRR: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest IRR more than cost of capital. If the firm has unlimited resouces, it can accept both projects A and C. This is because, both are projects are giving positive NPVs and are independent. Project D with IRR of 6% will not alter the answer. Among NPV and IRR decision will be taken based on NPV which satisfies wealth maximisation objective of Financial Management. If the cost of capital of A is 10%, it will not affect the IRR and decision will be same as IRR is more than k. NPV of C = 600*PVIF(1,7%) - 500 = 600*0.9345 - 500 = $60 IRR is the discount rate at which PV of cash inflows = PV of cash outflows IRR of A = 1,150*PVIF(1,k) = 1,000 PVIF(1,k) = 1000/1150= 0.869 refering PVIF table in 1 year, k= 16% IRR = 16% IRR of B = 560*PVIF(1,k) = 500 PVIF(1,k) = 500/560= 0.893 refering PVIF table in 1 year, k= 12% IRR = 12% IRR of C = 600*PVIF(1,k) - 500 PVIF(1,k) = 500/600= 0.833 refering PVIF table in 1 year, k= 20% IRR = 20% Decision : According to NPV: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest positive NPV According to IRR: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest IRR more than cost of capital. If the firm has unlimited resouces, it can accept both projects A and C. This is because, both are projects are giving positive NPVs and are independent. Project D with IRR of 6% will not alter the answer. Among NPV and IRR decision will be taken based on NPV which satisfies wealth maximisation objective of Financial Management. If the cost of capital of A is 10%, it will not affect the IRR and decision will be same as IRR is more than k. IRR of B = 560*PVIF(1,k) = 500 PVIF(1,k) = 500/560= 0.893 refering PVIF table in 1 year, k= 12% IRR = 12% IRR of C = 600*PVIF(1,k) - 500 PVIF(1,k) = 500/600= 0.833 refering PVIF table in 1 year, k= 20% IRR = 20% Decision : According to NPV: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest positive NPV According to IRR: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest IRR more than cost of capital. If the firm has unlimited resouces, it can accept both projects A and C. This is because, both are projects are giving positive NPVs and are independent. Project D with IRR of 6% will not alter the answer. Among NPV and IRR decision will be taken based on NPV which satisfies wealth maximisation objective of Financial Management. If the cost of capital of A is 10%, it will not affect the IRR and decision will be same as IRR is more than k. IRR of C = 600*PVIF(1,k) - 500 PVIF(1,k) = 500/600= 0.833 refering PVIF table in 1 year, k= 20% IRR = 20% Decision : According to NPV: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest positive NPV According to IRR: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest IRR more than cost of capital. If the firm has unlimited resouces, it can accept both projects A and C. This is because, both are projects are giving positive NPVs and are independent. Project D with IRR of 6% will not alter the answer. Among NPV and IRR decision will be taken based on NPV which satisfies wealth maximisation objective of Financial Management. If the cost of capital of A is 10%, it will not affect the IRR and decision will be same as IRR is more than k. IRR of C = 600*PVIF(1,k) - 500 PVIF(1,k) = 500/600= 0.833 refering PVIF table in 1 year, k= 20% IRR = 20% Decision : According to NPV: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest positive NPV According to IRR: Among Projects A and B, Firm has to select A. Among B and C it has to select C with highest IRR more than cost of capital. If the firm has unlimited resouces, it can accept both projects A and C. This is because, both are projects are giving positive NPVs and are independent. Project D with IRR of 6% will not alter the answer. Among NPV and IRR decision will be taken based on NPV which satisfies wealth maximisation objective of Financial Management. If the cost of capital of A is 10%, it will not affect the IRR and decision will be same as IRR is more than k.Related Questions
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