Fin 534

Week 4 Assignments

Chapter 6, Problem 3.

You are considering opening a new plant. The plant will cost $100 million upfront. After that, it is expected to produce profits of $30 million at the end of every year. The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8%. Should you make the investment? Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.

NPV = -100 + 30/8 = $275 million

IRR. 0=-100+30. IRR = 30% The maximum deviation allowable is no more than 30%.

Problem 13. Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for 10 years. The company will have to provide support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.

a. What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rate of 2% and 12%.

NPV = -5+PVprofits+PVsupport= -5+1/r(1-11+r10) - 0.1/r

r= 6%, NPV = $693,420.4

r = 2%, NPV = -$1,017,415

r = 12%, NPV = - $183,110.30

b. How many IRRs does this investment opportunity have?

There are 2 IRRs.

c. Can the IRR rule be used to evaluate this investment? Explain.

According to our text book, when we have 2 IRRs, the NPV should be used to evaluate the investment decision. So, we cannot use IRR.

Problem 24. You work for an outdoor play structure manufacturing company and are trying to decide between two projects. You can undertake only one project. If your cost of capital is 8%, use the incremental IRR rule to make the correct decision.

NPV = - 50 + 24/1+r +32/(1+r)2

r =-2(50)+24+242+450(32)/ 2(50) = 7.522%

IRR of 7.522% is less than the cost of capital of 8%, so we should take the...