Question

Suppose your firm would like to earn 10% yearly return from the following two investment projects of equal risk.

Year (t) Cash flows from Project A (Ct) Cash flows from Project B (Ct)

year        cash flow from project a           project b
0                       –$8,000                                     –$8,000
1                         $2,000                                     $4,000
2                      $3,000                                      $2,000
3                      $5,000                                    $2,500
4                       $1,000                                         $2,000

(a) If only one project can be accepted, based on the NPV method which one should it be? Support your answer with calculations. (9 marks)

(b) Suppose there is another four-year project (Project C) and its cash flows are as follows:

C0 = –$8,000
C1 =   $2,000
C2 =   $2,500
C3 =   $2,000
C4 =   $4,000

(i) Given the above cash flow patterns, at what required rate of return will Project C have the same NPV as Project B? Briefly explain your answer. (2 marks)

(ii) If Project C has the same risk as Project B, without calculations, explain which project will you pick? (2 marks)

(iii) If cash flow C4 of Project C is unknown to you (while C0 – C3 are known and as above) and the project’s cost of capital is 10%, what amount of C4 will make Project C worth accepting? (4 marks)

(iv) If your firm’s investment policy (based on payback method) is such that it only accepts projects whose initial investment can be recouped within three years, will Project B and/or Project C be accepted? (2 marks)

(c) Based on the estimated cash flows of Project A, will you expect its internal rate of return (IRR) to be positive? Briefly explain your answer WITHOUT calculations. (4 marks)

(d) What kind of rate of return is the 10% interest stated in the question for Projects A and B? How can it be used in making investment decisions (i.e. its role in investment decision making)?

Answer 1