FINA 3313 Ch 9

You are considering the following three mutually exclusive projects. The required rate of return for all three projects is 14%. Year A. B C 0 $(1,000) $(5,000). $(50,000) 1 $300 $1,700 $0 2 $300 $1,700 $15,000 3 $600 $1,700 $28,500 4 $300 $1,700 $33,000 What is the IRR of the best project? % terms to 2 decimal places w/o % sign

Find the NPV of all Projects. Then find the IRR of the project with the greatest NPV. IRR of best project (C) is 14.23%

***The financing decision

Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations

Advantages of NPV

-Gives a clear accept/reject decision -Uses all cash flows -Adjusts for risk w/ discount rate -Adjusts for TVM

The disadvantages of the IRR period method is that it

-Requires complex calculations -Only works for normal cash flows -Requires a lot of data (estimates of all CFs)

Disadvantages of IRR

-Requires complex calculations -Requires a lot of data (estimates of all CFs) -Only works for normal cash flows -Requires discount rate (for decision) -Does not always work for mutually exclusive projects

***The investment decision

Invest in assets that earn a rate greater than the minimum acceptable hurdle rate

The multiple IRR problem occurs when the signs of a project's cash flows change more than once.

True

Capital rationing may be beneficial to a firm if it:

Weeds out proposals with weaker or biased NPVs.

Advantages of IRR

-More intuitive than NPV -Gives a clear accept/reject decision for independent projects -Uses all Cash flows -Does not require a discount rate (for calculation) -Adjusts for TVM and therefore risk (in comparing to hurdle rate that adjusts for risk)

Disadvantages of NPV

-Requires complex calculations -Requires a lot of data (estimates of all CFs and R) -Dollar value is not always intuitive

What is the internal rate of return for a project with an initial outlay of $10,000 that is expected to generate cash flows of $2,000 per year for 6 years?

CF0= -10,000 C01= 2,000 F01= 6 IRR CPT IRR= 5.47

What is the profitability index for Project A with a cost of capital of 8%? Year. Project A Project B 0. ($42,000.00 ($45,000.00) 1 $14,000.00 $28,000.00 2 $14,000.00 $12,000.00 3 $14,000.00 $10,000.00 4 $14,000.00 $10,000.00 5 $14,000.00 $10,000.00

CF0= -42,000 C01= 14,000 F01=1 Do it until the 5th year -> Press NPV I= 8% CPT NPV = 13,897.94 PI= (NPV+CF0)/CF0 PI= (13,897.94+42,000)/42,000 PI= 1.33

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $900 at the end of the next three years and then $1400 per year for the three years after that. If the discount rate is 8% then what is the PI? Answer in % format

CF0= -5,000 C01=900 FO1=3 CO2= 1400 FO2=3 I=8 Enter down arrow Cpt NPV= 183.48 PI= (183.48+5,000)/5,000 PI= 1.03669 PI=103.67%

What is the NPV of a project that costs $100,000.00 and returns $50,000.00 annually for three years if the opportunity cost of capital is 8.22%?

CF0=-100,000 C01=50,000 F01=3 CPT NPV I/Y= 8.22% Down Arrow NPV CPT NPV=28,345.05

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $325 at the end of the next three years and then $1,653 per year for the three years after that. If the discount rate is 6.84% then what is the NPV?

CFO= -5,000 CO1= 325 FO1=3 CO2= 1,653 FO2=3 Enter -> NPV I= 6.84% Enter -> Down arrow ->CPT NPV= -577.15

It should not usually be clear whether we are describing independent or mutually exclusive projects in the following chapters because when we only describe one project then it can be assumed to be independent

False

NPV assumes intermediate cash flows are reinvested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital

False

Net present value (NPV) is a sophisticated capital budgeting technique; found by adding a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital.

False

List steps of the capital budgeting process

Step 1: Proposal generation Step 2: Review and analysis Step 3: Decision Making Step 4: Implementation Step 5: Follow-up

***Which of the following statements is correct for a project with a negative NPV?

The cost of capital exceeds the IRR

***Compute the payback period for a project that requires an initial outlay of $297,771 that is expected to generate $40,000 per year for 9 years.

Time Amount Cumulative (297,771) (297,771) 1 40,000 (257,771) 2 40,000 (217,771) 3 40,000 (177,771) 4 40,000 (137,771) 5 40,000 (97,771) 6 40,000 (57,771) 7 40,000 (17,771) 8 40,000 22,229 9 40,000 62,229 Look at the last number before going positive. =7+(17,771/40,000) =7.44

Disadvantages of Payback period

-Does not measure value -Does not fully adjust for TVM -Does not fully adjust for risk -No clear accept/reject decision -Ignores later CFs

What are advantages of payback period?

-Measures Liquidity, Easy to communicate -Does not require complex calculations -Does not require discount rate -Does not require all CFs -Can be used to compare mutually exclusive projects

***The dividend decision

If you can't find investments that make your minimum acceptable rate, return the cash to owners of your business

The primary purpose of capital budgeting is to:

Maximize the shareholders wealth

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Mutually Exclusive

The "gold standard" of investment criteria refers to:

NPV

The Internal Rate of Return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0

True

The multiple IRR problem occurs when the signs of a project's cash flows change more than once.

True