Reading 6: Discounted Cash Flow Applications-LOS b 习题精选 2011, net, investment, identify, problems

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

LOS b: Contrast the NPV rule to the IRR rule, and identify problems associated with 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) If two projects are mutually exclusive, one should always choose the project with the highest IRR.

B) Projects with a positive NPVs increase shareholder wealth.

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 $49,589 in present value terms.

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

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

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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.

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

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

B) shareholder wealth 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.

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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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Which of the following is NOT a problem with the internal rate of return (IRR)?

A) Sometimes the IRR exceeds the cost of capital.

B) Non-normal cash flow patterns may result in multiple IRRs.

C) A higher IRR does not necessarily indicate a more-profitable project.

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If the IRR exceeds the cost of capital, that merely indicates that the project is acceptable—this is not a problem associated with IRR. Non-normal cash flow patterns such as cash outflows during the project's life can result in multiple IRRs, leaving open the question as to which one is valid. A higher IRR will only be realized if the project’s cash flows can be reinvested at the IRR, and the true profitability of a project also depends on project size, not just IRR.

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Which of the following is least likely a problem associated with the internal rate of return (IRR) method for making investment decisions?

A) The IRR method determines the discount rate that sets the net present value of a project equal to zero.

B) An investment project may have more than one internal rate of return.

C) IRR and NPV criteria can give conflicting decisions for mutually exclusive projects.

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The IRR method equates an investment’s present value of inflows to its present value of outflows. The IRR by definition is the discount rate that sets the net present value of a project equal to zero. Therefore, the decision rule for independent projects is as follows: if the IRR is above the firm’s cost of capital, the project should be accepted, and if the IRR is below the cost of capital, the project should be rejected.

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Sarah Kelley, CFA, is analyzing two mutually exclusive investment projects. Kelley has calculated the net present value (NPV) and internal rate of return (IRR) for each project:

Project 1: NPV = $230; IRR = 15%

Project 2: NPV = $4,000; IRR = 6%

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

A) Accept Project 1 only.

B) Accept both projects.

C) Accept Project 2 only.

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Because the investment projects are mutually exclusive, only one project can be chosen. The NPV and IRR criteria are giving conflicting project rankings. When decision criteria conflict, always use the NPV criteria because NPV evaluates projects using an appropriate discount rate, the weighted average cost of capital. The IRR may not be a market rate, therefore future cash flows associated with the project may not be capable of earning a rate of return equal to the IRR.

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The internal rate of return (IRR) method and net present value (NPV) method of project selection will always provide the same accept or reject decision when:

A) the projects are mutually exclusive.

B) the projects are independent.

C) up-front project costs are under $1.0 million.

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If a project’s IRR exceeds the cost of capital, the project’s NPV will be positive. The only way in which accepting a positive NPV project would reduce firm value is if its selection precludes selection of a project that would have enhanced firm value to a greater extent (i.e., had a higher NPV). IRR and NPV method accuracy do not depend upon project duration or costs.