A firm has the following
investment alternatives:
Cash Inflows
A B C
Year
1 $1,100 $3,600 -----
Year
2
1,100 ----- -----
Year
3 1,100 ----- $4,562
Each investment costs $3,000;
investments B and C are mutually exclusive, and the firm’s cost of capital is 8
percent.
a. What is the net present value
of each investment
b. According to the net present
values, which investment(s) should the firm make? Why?
c. What is the internal rate of
return on each investment?
d. According to the internal
rates of return, which investment(s) should the firm make? Why?
e. According to both the net
present values and internal rates of return, which investments should the firm
make?
f. If the firm could reinvest the
$3,600 earned in year one from investment B at 10 percent, what effect would
that information have on your answer to part e? Would the answer be different if the rate were 14 percent?
g. If the firm’s cost of capital
had been 10 percent, what would be investment A’s internal rate of return?
h. The payback method of capital
budgeting selects which investment? Why?
TUTORIAL PREVIEW
Determination of the net present values:
year
|
Project A
|
Project B
|
Project C
| ||||||
Cash flow
|
PV factor @ 10%
|
PV of cash flows
|
Cash flow
|
PV factor @ 10%
|
PV of cash flows
|
Cash flow
|
PV factor @ 10%
|
PV of cash flows
| |
1
|
1100
|
0.926
|
1018.5
|
3600
|
0.926
|
3333.3
|
-
| ||
2
|
1100
|
0.857
|
943.1
|
-
|
-
| ||||
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