Investments Quick and Slow cost $1,000 each, are mutually exclusive, and have th

Question

Investments Quick and Slow cost $1,000 each, are mutually exclusive, and have the following cash flows. The firm's cost of capital is 10%: Year 1: Cash Inflows (Quick)= $1,300, (Slow)= $386. Year 2: Cash Inflows (Q)= $0, (S)= $386. Year 3: Cash Inflows (Q)= $0, (S)= $386. Year 4: Cash Inflows (Q)= $0, (S) $386.

a.) According to the net present value method of capital budgeting, which investment(s) should the firm make? b.) According to the internal rate of return method of capital budgeting, which investment(s) should the firm make? c.) If Q is chosen, the $1,300 can reinvested and earn 12%. Does this information alter your conclusion concerning investing in Q and S? To answer, assume that S's cash inflows can be reinvested at its internal rate of return. Would your answer be different if S's cash flows were reinvested at the cost of capital (10%)?

Explanation / Answer

11. a. Net present value of Q: NPVS = $1,300/(1 + .1) $1,000 = $1,181.70 $1,000 = $181.70 Net present value of S: $386(PVAIF 10I, 4N) $1,000 = $386(3.170) $1,000 = $223.62 Since the investments are mutually exclusive, the firm can only make one and will select S because its net present value is higher. b. Internal rate of return for Q: $1,000 = $1,300/(1 + rQ) (1 + rQ) = $1,000/$1,300 = .769 rQ = 30% Internal rate of return for S: $386(PVAIF ?I, 4N) = $1,000 Interest factor = $1,000/386 = 2.591 rS = 20% Since the investments are mutually exclusive, the firm can only make one and will select Q because its internal rate of return is higher. (This answer contradicts the answer to part a.) c. Reconciliation depends on what the firm can do with the $1,300 earned in year 1 by investment Q. In this part the funds can be reinvested at 12%, so the terminal value of investment Q is $1,300(1 + .12)^t = $1,300(1.405) = $1,826.50 The terminal value of S also depends on the reinvestment rate, which is S's internal rate of return of 20%. $386(FVAIF 20I, 4N) = $386(5.386) = $2,072.05 Since the terminal value of S is larger, it is preferred to Q. However, if the reinvestment rate of S had been the cost of capital (10%), then terminal value of S would have been $386(4.641) = $1,791.42, and investment Q would have been selected. This problem illustrates the importance of the reinvestment rate.

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