Reading 6: Discounted Cash Flow Applications-LOS a, (Part 2) 2010, net, investment, present, return

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Session 2: Quantitative Methods: Basic Concepts
Reading 6: Discounted Cash Flow Applications

LOS a, (Part 2): Contrast the NPV rule to the IRR rule.

 

 

 

Jack Smith, CFA, is analyzing independent investment projects X and Y. Smith has calculated the net present value (NPV) and internal rate of return (IRR) for each project:

Project X: NPV = $250; IRR = 15%

Project Y: NPV = $5,000; IRR = 8%

Smith should make which of the following recommendations concerning the two projects?

A) Accept Project X only.

B) Accept both projects.

C) Accept Project Y only.

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The projects are independent, meaning that either one or both projects may be chosen. Both projects have positive NPVs, therefore both projects add to shareholder wealth and both projects should be accepted.

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Which of the following statements regarding making investment decisions using net present value (NPV) and internal rate of return (IRR) is least accurate?

A) Projects with a positive NPVs increase shareholder wealth.

B) If two projects are mutually exclusive, one should always choose the project with the highest IRR.

C) If a firm undertakes a zero-NPV project, the firm will get larger, but shareholder wealth will not change.

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If two projects are mutually exclusive, the firm should always choose the project with the highest NPV rather than the highest IRR. If two projects are mutually exclusive, the firm may only choose one. It is possible for NPV and IRR to give conflicting decisions for projects of different sizes. Because NPV is a direct measure of the change in shareholder wealth, NPV criteria should be used when NPV and IRR decisions conflict.

When a project has a positive NPV, it will add to shareholder wealth because the project is earning more than the opportunity cost of capital needed to undertake the project. If a firm takes on a zero-NPV project, the firm will earn exactly enough to cover the opportunity cost of capital. The firm will increase in size by taking the project, but shareholder wealth will not change.

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Williams Warehousing currently has a warehouse lease that calls for five annual payments of $120,000. The warehouse owner, who needs cash, is offering Williams a deal wherein Williams will pay $200,000 this year and then pay only $80,000 each of the remaining 4 years. (Assume that all lease payments are made at the beginning of the year.) Should Williams Warehousing accept the offer if its required rate of return is 9%, and why?

A) Yes, there is a savings of $45,494 in present value terms.

B) No, there is an additional $80,000 payment in this year.

C) Yes, there is a savings of $49,589 in present value terms.

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The present value of the current lease is $508,766.38, while the present value of the lease being offered is $459,177.59; a savings of 49,589. Alternatively, the present value of the extra $40,000 at the beginning of each of the next 4 years is $129,589 which is $49,589 more than the extra $80,000 added to the payment today.

bmaggie

Financial managers should always select the project that provides the highest net present value (NPV) whenever NPV and IRR methods conflict, because maximizing:

A) shareholder wealth is the goal of financial management.

B) the shareholders' rate of return is the goal of financial management.

C) revenues is the goal of financial management.

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Focusing on the maximization of earnings does not consider the differences in risk across projects, while focusing on revenues precludes concern for the expenses incurred. Earning a higher return on a small project provides less of a benefit than earning a slightly lower rate of return on a much larger project.

bmaggie

The financial manager at Johnson & Smith estimates that its required rate of return is 11%. Which of the following independent projects should Johnson & Smith accept?

A) Project C requires an up-front expenditure of $600,000 and generates a positive internal rate of return of 12.0%.

B) Project A requires an up-front expenditure of $1,000,000 and generates an NPV of -$4,600.

C) Project B requires an up-front expenditure of $800,000 and generates a positive IRR of 10.5%.

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When projects are independent, you can use either the NPV method or IRR method to make the accept or reject decision. Only Project C has an IRR in excess of 11%. Acceptance of Project A reduces the firm’s value by $4,600.

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