andytrader

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.

andytrader

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 Project Y only.

C) Accept both projects.

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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.

andytrader

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.

andytrader

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) Yes, there is a savings of $49,589 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.