chp 7 Flashcards
(42 cards)
A project has an initial cost of $15,000. The future cash flows are $3,200, $6,100, -$1,100, and $18,200 for Years 1 to 4, respectively. How many IRRs will this project have?
3
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the
payback period.
The discount rate that makes the NPV of an investment exactly equal to zero is called the
IRR
What is the primary shortcoming of the average accounting rate of return from a financial perspective?
The use of net income rather than cash flows
If the discounted payback method is preferable to the payback method, then why is the payback method ever used?
Payback is easier to compute than discounted payback.
An investment is acceptable if the profitability index of the investment is
greater than one.
A firm should accept projects with positive NPVs primarily because those projects will
create value for the firm’s current stockholders.
Analysis using the profitability index
is useful as a decision tool when investment funds are limited.
The discounted payback method
uses an arbitrary cutoff period.
All else constant, the NPV of a typical investment project increases when
the rate of return decreases.
All else equal, the payback period for a project will decrease whenever the
cash inflows are moved earlier in time.
Which methods of project analysis are most biased towards short-term projects?
Payback and discounted payback
A project with conventional cash flows has an NPV of -$500, an IRR of 9.5%, and a payback period of 4.2 years. Given this information, an analyst would be justified in concluding that
the required rate of return is greater than 9.5 percent.
The payback method
ignores the time value of money.
What is the IRR on an investment that has an initial cost of $63,100 and projected cash inflows of $18,700, $38,600, and $34,100 for Years 1 to 3, respectively?
19.10
NPV = $0 = –$63,100 + $18,700 / (1 + IRR) + $38,600 / (1 + IRR)2 + $34,100 / (1 + IRR)3
IRR = .1910 or 19.10%
A project has an initial cost of $240,000 and cash flows of $78,000, –$22,000, and $164,000 for Years 1 to 3, respectively. If the required rate of return for this investment is 17 percent, should you accept it based solely on the IRR rule? Why or why not?
You cannot apply the IRR rule in this case because there are multiple IRRs.
Since the cash flow in Year 2 is a negative value, there are multiple IRRs. Thus, the IRR rule does not apply.
A project is expected to have annual cash flows of $36,800, $24,600, and –$9,200 for Years 1 to 3, respectively. The initial cash outlay is $44,500 and the discount rate is 11 percent. What is the modified IRR using the discounting approach?
13.97%
Modified Year 0 cash flow = –$44,500 + (–$9,200/1.113) = –$51,226.96
$0 = –$51,226.96 + $36,800/(1 + MIRR) + $24,600/(1 + MIRR)2 MIRR = .1397, or 13.97%
A project requires an initial investment of $135,000 and will produce cash inflows of $120,000, $175,000, and $340,000 over the next 3 years, respectively. What is the project’s NPV at a required return of 14 percent?
$334,410
Using a financial calculator CF0 = –135,000, CF1 = 120,00, CF2 = 175,000, CF3 = 340,000 , I/YR = 14, Solve for NPV = $334,410. Or: $120,000/(1 + .14) + $175,000/(1 + .14)2 + $340,000/(1 + .14)3 – $135,000 = $334,410.
Project Q has an initial cost of $257,412 and projected cash flows of $123,300 in Year 1 and $180,300 in Year 2. Project R has an initial cost of $345,000 and projected cash flows of $184,500 in Year 1 and $230,600 in Year 2. The discount rate is 12.2 percent and the projects are independent. Which project(s), if either, should be accepted based on its profitability index value?
Accept Project R and reject Project Q
PIQ = ($123,300 / 1.122 + $180,300 / 1.1222) / $257,412 = .98; Reject
PIR = ($184,500 / 1.122 + $230,600 / 1.1222) / $345,000 = 1.01; Accept
The Walk-Up Window is considering two mutually exclusive projects. Project A has an initial cost of $64,230 and annual cash flows of $25,200 for 3 years. Project B has an initial cost of $45,400 and annual cash flows of $21,400, $21,900, and $10,200 for Years 1 to 3, respectively. What is the incremental IRRA–B? Which project should be accepted if the discount rate is 9 percent? Which project should be accepted if the discount rate is 6 percent?
6.65%; Project B; Project A
Incremental cash flows: Time 0: –$64,230 – (–$45,400) = –$18,830 Year 1: $25,200 – $21,400 = $3,800 Year 2: $25,200 – $21,900 = $3,300 Year 3: $25,200 – $10,200 = $15,000
Incremental IRRA–B = –$18,830 + $3,800 / (1 + IRR) + $3,300 / (1 + IRR)2 + $15,000 / (1 + IRR)3
Incremental IRRA–B = 0.0665, or 6.65%
NPVA = –$64,230 + $25,200 / 1.09 + $25,200 / 1.092 + $25,200 / 1.093 = –$441.37 NPVB = –$45,400 + $21,400 / 1.09 + $21,900 / 1.092 + $10,200 / 1.093 = $542.09 NPVA = –$64,230 + $25,200 / 1.06 + $25,200 / 1.062 + $25,200 / 1.063 = $3,129.90 NPVB = –$45,400 + $21,400 / 1.06 + $21,900 / 1.062 + $10,200 / 1.063 = $2,843.72
Turner Enterprises is analyzing a project that is expected to have annual cash flows of $46,400, $51,300 and –$15,200 for Years 1 to 3, respectively. The initial cash outlay is $65,900 and the discount rate is 12 percent. What is the MIRR using the discounting approach?
17.43%
Modified Year 0 cash flow = –$65,900 – $15,200/1.123 = –$76,719.10
$0 = –$76,719.10 + $46,400/(1 + MIRR) + $51,300/(1 + MIRR)2 MIRR = .1743, or 17.43%
Project A has an initial cost of $211,400 and projected cash flows of $46,200, $64,900, and $135,800 for Years 1 to 3, respectively. Project B has an initial cost of $187,900 and projected cash flows of $43,200, $59,700, and $125,600 for Years 1 to 3, respectively. What is the incremental IRRA–B of these two mutually exclusive projects?
−9.62% Incremental cash flows: Time 0: –$211,400 – (–$187,900) = –$23,500 Year 1: $46,200 – $43,200 = $3,000 Year 2: $64,900 – $59,700 = $5,200 Year 3: $135,800 – $125,600 = $10,200
Incremental IRRA–B = –$23,500 + $3,000 / (1 + IRR) + $5,200 / (1 + IRR)2 + $10,200 / (1 + IRR)3
IRR = –.0962, or –9.62%
You are considering two independent projects that each have a required return of 15 percent. Project A has an initial cost of $198,700 and cash inflows of $67,200, $109,600, and $88,700 for Years 1 to 3, respectively. Project B has an initial cost of $102,000 and cash inflows of $37,600 and $91,200 for Years 1 and 2, respectively. Given this information, which one of the following statements is correct based on the NPV and IRR methods of analysis?
You should accept Project A and reject Project B.
NPVA = –$198,700 + $67,200 / 1.15 + $109,600 / 1.152 + $88,700 / 1.153
NPVA = $929.82; Accept
$0 = –$198,700 + $67,200 / (1 + IRR) + $109,600 / (1 + IRR)2 + $88,700 / (1 + IRR)3 IRR = .1527, or 15.27%; Accept
NPVB = –$102,000 + $37,600 / 1.15 + $91,200 / 1.152 NPVB = –$344.05; Reject
$0 = –$102,000 + $37,600 / (1 + IRR) + $91,200 / (1 + IRR)2 IRR = .1477, or 14.77%; Reject
Dorian International has $75,000 that it can invest for two and half years. After that, the funds are needed to repay an outstanding bond issue. The company has two potential projects that are within the funding limit. Project A has an initial cost of $40,000 and cash flows of $24,000 a year for two years. Project B has an initial cost of $75,000 and cash flows of $27,000 a year for four years. If the required rate of return on both projects is 12 percent, what is your recommendation?
Accept Project A and reject Project B
Because the company must have the funds returned within two and a half years, any project that can be accepted must pay back within two and half years and also have a positive NPV.
PaybackA = 1 + ($40,000 – $24,000) / $24,000 = 1.67 years; Project A meets the payback requirement.
PaybackB = 2 + ($75,000 – $27,000 – $27,000) / $27,000 = 2.78 years; Project B must be rejected because it does not meet the mandatory payback period of 2.5 years.
NPVA = –$40,000 + $24,000 / 1.12 + $24,000 / 1.12 = $561.22; Project A passes the NPV test.
