Question

16 of 16 (11 complete) HW Score: 56.88%, 11.38 of 20 pts Score: 0 of 1 pt P10-28 (book/static) Question Help Problems with IRR White Rock Services Inc. has an opportunity to make an investment with the following projected cash flows. Year Cash Flow $1,690,000 - 3,887,000 2,225,025 a. Calculate the NPV at the following discount rates and plot an NPV profile for this investment: 0%, 5%, 7.5%, 10%, 15%, 20%, 22.5%, 25%, 30%. b. What does the NPV profile tell you about this investment's IRR? c. If the company follows the IRR decision rule and their cost of capital is 15%, should they accept or reject the opportunity? Why is it hard to make a decision on this investment based solely on the IRR rule? d. If the company's cost of capital is 15%, should they reject or accept the investment based on its NPV? a. Calculate the NPV at the following discount rates for this investment: 0%, 5%, 7.5%, 10%, 15%, 20%, 22.5%, 25%, 30%. The NPV at 0% is $ . (Round to the nearest cent.) Enter your answer in the answer box and then click Check Answer.

Answer 1

NPV = present value of cash inflow- the present value of cash outflow.

Discounted at the cost of capital/required rate of return.

NPV must be positive to accept the project.

If the projects are mutually exclusive then the project with highest net present value will be preferred.

a.
NPV at 0% = {1,690,000+[2,225,025/(1.0)^2]}-[3,887,000/(1.0)^1] = $28025

NPV at 5% = {1,690,000+[2,225,025/(1.05)^2]}-[3,887,000/(1.05)^1] = $6258.50

NPV at 7.5% = {1,690,000+[2,225,025/(1.075)^2]}-[3,887,000/(1.075)^1] = -$427.25

NPV at 10% = {1,690,000+[2,225,025/(1.10)^2]}-[3,887,000/(1.10)^1] =- $4772.73

NPV at 15% = {1,690,000+[2,225,025/(1.15)^2]}-[3,887,000/(1.15)^1] = -$7561.44

NPV at 20% = {1,690,000+[2,225,025/(1.20)^2]}-[3,887,000/(1.20)^1] = -4,010.41

NPV at 22.5% = {1,690,000+[2,225,025/(1.225)^2]}-[3,887,000/(1.225)^1] = -$329.03

NPV at 25% = {1,690,000+[2,225,025/(1.25)^2]}-[3,887,000/(1.25)^1] = +$4416

NPV at 30% = {1,690,000+[2,225,025/(1.30)^2]}-[3,887,000/(1.30)^1] = +$16,582.84

b. The NPV profile is decreasing with increase in discount rate. After a certain point it is reversing the trend i.e it is increasing with an increase in discount rate.
So IRR of this project can be ambiguous Because IRR does not measure the absolute return of the project, As IRR is just a relative measure.

c. IRR: It is the discount rate at which the present value of projects cash outflows (cost) is equal to the present value of projects cash inflow.

IRR of the project = {1,690,000+[2,225,025/(1+IRR)^2]}=[3,887,000/(1+IRR)^1]

IRR = 7.31%

The IRR must be above the cost of capital (15%) in order to accept the project.

We need to reject this project as per IRR rule.

The reason why it is difficult to take decision with internal rate of return rule:
The decision taken by IRR rule may not always be correct due to the following reasons as it can have a conflicting issue with other capital budgeting techniques.

The NPV and IRR can lead to a conflicting decision because
1. The distribution of cash flow in the projects.
2. The size of the project.

NPV absolute measure whereas IRR is a relative measure.
NPV gives absolute dollar returns.
IRR are reinvest the cash flow at IRR rate, which is not true and hence not a better technique.

Npv is a better technique then compared to the internal rate of return.

d. the project should not be accepted because net present value is negative (-$7561.44) at 15% discount rate.