Assume that the interest rate is greater than zero. Which of the following cash-inflow streams should you prefer?
Answer(s): A
The concept of present value gives greater value to inflows received earlier in the stream. Thus, the declining inflows would be superior to increasing inflows, or even inflows.
Wilkinson, Inc., which has a cost of capital of 12%, invested in a project with an internal rate of return (IRR) of 14%. The project is expected to have a useful life of four years, and it will produce net cash inflows as follows:The initial cost of this project amounted to
The internal rate of return (IRP) of a capital project is the rate at which the net present value (NPV) of its future cash flows equals zero. To find this project's NPV, therefore, it is necessary to discount the cash flows at the appropriate rate (14%) as follows:
Gibber Corporation has an opportunity' to sell newly developed product in the United States for a period of five years. The product license would be purchased from New Group Company. Gibber would be responsible for all distribution and product promotion costs. New Group has the option to renew the agreement, with modifications, at the end of the initial five-year term. Gibber has developed the following estimated revenues and costs that would be associated with the new product:The working capital required to support the new product would be released for investment elsewhere if the product licensing agreement is not renewed. Using the net present value method of analysis and ignoring the effects of income taxes, the net present value of this product agreement, assuming Gibber has a 20% cost of capital, would be
The net present value of a capital project is derived by calculating three amounts and discounting them at the appropriate interest rate: the net initial investment (for which the rate is always 0%), the annual cash inflows, and the termination cash inflows. The net initial investment itself consists of three components: the purchase of new equipment, the increase in working capital, and the proceeds from the disposal of any old equipment. For this project, this amount is $320000 ($120,000 + 200,000 + $0). Since this amount is paid out today, its present value is $320,000, i.e., no discounting is performed. The second element of the project as a whole is the annual cash inflows. This has two components: the cash inflows from operations and the depreciation tax shield arising from the purchase of new equipment. Since the effects of income taxes are not relevant to this problem, only the first of these components requires calculation. The annual net operating revenue is $80,000 ($400,000--$250,000--$70,000). Discounted as an ordinary annuilyfor5 years at 20%, its present value is $239,280 ($80,000 x 2.991). The third and final element is the cash flows upon termination of the project, consisting of the proceeds from the disposal of the equipment involved in the project (again, the effects of income taxes are ignored for this problem) and the recovery of working capital. For this project, this amount is $220,000 ($20,000 + $200,000). Discounted as a single amount to be received in 5 years at 20%, its present value is $88,440 ($220,000 x 0.402). Gibber's total net present value for this capital project can therefore be calculated as follows:
Benet, Inc. uses the net present value method to evaluate capital projects. Bonnet's required rate of return is 10%. Benet is considering two mutually exclusive projects for its manufacturing business. Both projects require an initial outlay of $120,000 and are expected to have a useful life of four years. The projected after-tax cash flows associated with these projects are as follows:Assuming adequate funds are available, which of the following project options would you recommend that Bennet's management undertake?
The net present value of Project X can be determined using the present value factor for an annually (3.170) because the cash flows are even over the life of the project. An ordinarqannuilyof$401000 discounted at 10% for the next four years has a present value of $1 26800. The cash inflows of Project Y are uneven and so must be discounted with individual factors for each of the four years as follows:Since the projects are mutually exclusive, the one with the higher net present value is the correct choice.
50. Brown and Company uses the internal rate of return (IRR) method to evaluate capital projects. Brown is considering four independent projects with the following lRRs:Brown's cost of capital is 13%. Which one of the following project options should Brown accept based on IRR?
Answer(s): B
When sufficient funds are available, any capital project whose internal rate of return (IRR) exceeds the company cost of capital should be accepted.
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