Question

SLIDII 2 Suppose that you are investigating two mutual exclusive investments (investment A and B) which correspond to two listed firms A and B, respectively. The Net Cash Flows of these investments are the following: 13 100 (10,000) (10,000) 11,500 0 ogs B 13,500 The risk free interest rate is 2% and the market portfolio return is 8%. The beta coefficient (systematic risk) for firm A and B is equal to 0.5 (i.e. ba=bg=0.5) Which investment would you proceed with according to the Net Present Value (NPV) and the Internal Rate of Return (IRR) investment appraisal techniques? Is there any difference in the decisions made, based on the NPV and the IRR criteria? Explain. (70%) What is the range of interest rates for which the NPV and the IRR would coincide to the same decision? (30%)

Answer 1

A C D E F G Using CAPM, 1 2 Discount rate Risk free rate Beta Market risk premium 3 Risk free rate 0.02 5 Market return 0.08 6 Market risk premium -C5-C4 7 Beta 0.5 8 Discount rate -C4+C6*C7 10 - E10 + 1 0 -C10+1 -D10+1 11 Net cash flow 11500 -10000 100 100 - E12 / ( 1 +5 % ) -D12/(1+ 5 % ) -C12/(1+5 % ) 12 Discounting factor @ 5% 1 -C11*C12 13 Discounted net cash flow -D11* D12 -E11*E12 -F11*F12 14 -SUM(C13:F13) IRR(C11:F11) 15 NPV 16 IRR 17 - D18 + 1 18 0 -C18 + 1 - E18 + 1 13500 19 Net cash flow -10000 0 0 C20/ (1+5 % ) 20 Discounting factor @ 5% =D20/(1+5%) - E19*E20 -E20/(1+5%) 1 -C19*C20 -F19* F20 21 Discounted net cash flow D19* D20 22 23 SUM(C21:F21) NPV IRR(C19:F19) 24 IRR 25 26 Using NPV, select B, since NPV of B is higher than A 27 Using IRR, select A, since IRR of A is higher than B 28 When NPV and IRR give contradictory results, one should choose NPV criteria for decision making 29

J. A C D E F Н I Using CAPM, 1 2 Discount rate Risk free rate Beta * Market risk premium 3 Risk free rate 4 2% Market return 5 8% Market risk premium 6 6% 7 Beta 0.50 8 Discount rate 5% 9 10 A 0 1 2 3 11 Net cash flow -10,000 11,500 100 100 12 Discounting factor @ 5% 1.00 0.95 0.91 0.86 13 Discounted net cash flow -10,000 10,952 91 86 14 15 NPV 1,129 16 16.6% IRR 17 18 0 1 2 19 Net cash flow -10,000 13,500 Discounting factor @ 5% 20 1.00 0.95 0.91 0.86 21 Discounted net cash flow 11,662 -10,000 22 23 NPV 1,662 10.5% 24 IRR 25 26 Using NPV, select B, since NPV of B is higher than A 27 Using IRR, select A, since IRR of A is higher than B 28 When NPV and IRR give contradictory results, one should choose NPV criteria for decision making 29 LL