Fin515W5 Hwandproject

Chapter 7

Investment Decision Rules

7-20. You are considering making a movie. The movie is expected to cost $10 million upfront and take a year to make. After that, it is expected to make $5 million when it is released in one year and $2 million per year for the following four years. What is the payback period of this investment? If you require a payback period of two years, will you make the movie? Does the movie have a positive NPV if the cost of capital is 10%?

Timeline:

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It will take 5 years to pay back the initial investment, so the payback period is 5 years. You will not make the movie.

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So the NPV agrees with the payback rule in this case.

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|-10 |5 |2 |2 |2 |2 |

|Payback = |4 years | | | | |

|NPV at 10% = |$0.31 |million | | |

7-21. You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its revenues will grow at 2% per year for every year after that.

a. Which investment has the higher IRR?

b. Which investment has the higher NPV when the cost of capital is 7%?

c. In this case, for what values of the cost of capital does picking the higher IRR give the correct answer as to which investment is the best opportunity?

a. Timeline:

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