Finance

Chapter 5

Net Present Value and Other Investment Criteria

Question 6: IRR rule

Consider projects Alpha and Beta

Cash Flows ($) |

Project | C0 | C1 | C2 | IRR (%) |

Alpha | -400,000 | +241,000 | +293,000 | 21 |

Beta | -200,000 | +131,000 | +172,000 | 31 |

Suppose you can undertake Alpha and Beta, but not both. Use the IRR rule to make the choice (Hint: What’s the incremental investment in Alpha?)

Answer

The incremental flows from investing in Alpha rather than Beta are −200,000; +110,000; and 121,000. The IRR on the incremental cash flow is 10% (i.e., −200 + 110/1.10 + 121/1.102 = 0). The IRR on Beta exceeds the cost of capital and so does the IRR on the incremental investment in Alpha. Choose Alpha.

12. Answer

a. Because Project A requires a larger capital outlay, it is possible that Project A has both a lower IRR and a higher NPV than Project B. (In fact, NPVA is greater than NPVB for all discount rates less than 10%.) Because the goal is to maximize shareholder wealth, NPV is the correct criterion.

b. To use the IRR criterion for mutually exclusive projects, calculate the IRR for the incremental cash flows:

| C0 | C1 | C2 | IRR |

A - B | −200 | +110 | +121 | 10% |

Because the IRR for the incremental cash flows exceeds the cost of capital, the additional investment in A is worthwhile.

c.

Chapter 6

Making Investment Decision with the Net Present Value Rule

Question 1: Cash flows

Which of the following should be treated as incremental cash flows when deciding whether to invest in a new manufacturing plant? The site is already owned by the company, but existing building would need to be demolished.

a. The market value of the site and existing buildings.

b. Demolition costs and site clearance

c. The cost of a new access road put in last year

d. Lost earnings on other products due to executive time spent on the new facility.

e. A proportion of...