Question

- The projected cash flows For 2 indepelent are given below. The reauired return for both projeas 13%. Given this information which statements is correct? (A) accept A if you could increase the intial cost of the project B accept A Cello and reject proiect B based on their respective N PVS c) accept project B į reject project on - based on their respetive NPVS d reject B & reject A based on their respective IRRS C you should accept both A & B based on their respective IRRS. A project B geen protect co-15 000 74,000 74,000 - 1²5,000 60.000 60.000 40.000 74 000 23 C 2 NPV is more useful than the internal rate of return when compa differeat sized independent a projects I True or dee false 1² the increases increase if market risk Premium riske free rate must also true orfalse <strue Mote 4 Realized returns are generally not equal to expected returns, there is both expecte pected expected component to expected componen Fanit retur n

Answer 1

Solutions:

1) The solution is choice c viz. to accept project B and reject project A as project B has a positive NPV whereas the NPV of project A is negative. The calculations are given below:

Discounting both project cash flows @ 13% we get NPVs of both projects as follows: (formulas provided below)

PV of annuity = A x [(1+r)ⁿ - 1] $\div$ [ r x (1+r)ⁿ ] ….. A = annuity; r = rate per period; n = number of periods

PV of single cash flow = C $\div$ (1+r)ⁿ ….C = cash flow; r = rate per period; n= number of periods after which it is received

Project A:

-175,000 + {74,000 x [(1+0.13)³ - 1] $\div$ [0.13 x (1+0.13)³ ] }………. (adding initial investment to formula for PV of an annuity)

= -175,000 +{74,000 x 0.4429 $\div$ 0.1876} ….. (1.13³ = 1.4429)

= -175,000 + 174,704.69

= -295.31

Project B:

-125,000 + {60,000 x [(1+0.13)² - 1] $\div$ [0.13 x (1+0.13)² ] } + [40,000 $\div$ (1+0.13)³] …. (adding initial investment to formula for PV of an annuity and PV of a single cash flow)

= -125,000 + {60,000 x 0.2769 $\div$ 0.1660} + [40,000 x 0.6930]    …… (1.13² = 1.2769 and 1 $\div$ 1.13³ = 1 $\div$ 1.4429 = 0.6930)

= -125,000 + 100,084.34 + 27,720

= 2,804.34

2) Statement is false. Internal rate of return is more useful than NPV when independent projects have different sizes.

3) Statement is false. Market risk premium is independent of the risk free rate and does not affect the risk free rate.

4) Statement is true. Realised returns generally do not equate expected returns because of the unexpected component that causes the error or deviation from expected return.