Directions: Answer the following five questions on a separate document. Explain

Question

Directions: Answer the following five questions on a separate document. Explain how you reached the answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using the assignment link in the course shell. Each question is worth five points apiece for a total of 20 points for this homework assignment.
1. Which of the following statements is CORRECT?
a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
2. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project’s cash flows come in the early years, while most of the other project’s cash flows occur in the later years. The two NPV profiles are given below:
Which of the following statements is CORRECT?
a. More of Project A’s cash flows occur in the later years. b. More of Project B’s cash flows occur in the later years. c. We must have information on the cost of capital in order to determine which project has the
larger early cash flows. d. The NPV profile graph is inconsistent with the statement made in the problem. e. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater
than either project’s IRR.
3. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?
a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).
b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).
c. The firm will accept too many projects in all economic states because a 4-year payback is too low.
d. The firm will accept too few projects in all economic states because a 4-year payback is too high.
e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.
4. You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and - $100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?
a. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC.
b. You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC.
c. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that the firm’s value will increase if the project is accepted.
d. You should recommend that the project be rejected. Although its NPV is positive it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted.
e. You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm’s value will decline if it is accepted.
5. A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose?
WACC: 6.00%
Year 01234 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765
a. $188.68
b. $198.61
c. $209.07 d. $219.52 e. $230.49

Explanation / Answer

1) SOL: BY GIVEN STATEMENTS CORRECT OPTION IS “D” First we analyze all the statements which is given Statement “a”: The internal rate of return method is one of the discounted cash flow technique. IRR is expressed in terms of the percentage return .A firm expects the capital project return. In this method we calculate the IRR by using percentages . that is not given in the project . we have to estimate the percentage then calculate the IRR . this is known as the trail and error method . This is not a correct option. Statement “b”: The payback period method is one of the traditional method . payback period represents the time period required for the complete recovery of the intial investment in the project. This method have some disadvantages so this is not at all single method for evaluating capital budgets. For Pay back period calculation this formula is used : PBP = INTIAL INVESTMENT ANNUAL CASH FLOWS This is not a correct option Statement “C”: The discounted payback method is not generally regarded by academics as being the best single method for evaluating capital budgeting projects. This is not a correct option Statement “D”: THE NET PRESENT VALUE METHOD IS ONE OF THE DISCOUNTED CASH FLOW TECHINIQUE . NPV IS CALCULATED IN TERM OF CURRENCY . ACADEMIC EVIDENCE SUGGESTS THAT THE NPV METHOD IS PREFERRED OVER THE OTHER METHODS . SINCE IT CALCULATES ADDITIONAL WEALTH FOR NPV CALCULATION FOLLOWING FORMULA IS USED NPV = CASH IN FLOWS – CASH OUT FLOWS By calculating net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. THIS IS THE CORRECT OPTION “” D “ “ 2.) SOL: BY GIVEN STATEMENTS OPTION “A” IS CORRECT BECAUSE OF Assuming these projects are mutually exclusive, the circumstances that lead to conflict include this: project a generating less cash flow in the first couple of years and then generating most of total cash flow in the last years of the project. project b is the opposite. it is generating most of its cash flow in the first couple of years and then generating the least in the last years of the project. When everything is summed up for the two projects, project a has generated more cash flow than project b remember that we are discounting the cash flows. So, project a having most of its cash flow in the last years meant it had to be discounted back more years, resulting in less present value. project b having most of its cash flow in the first years led to a greater return when NPV is zero. ¬¬¬¬¬¬¬¬3) GIVEN STAE CORRECT OPTION IS “””A”” Because of NPV has three attributes. 1. NPV uses cash flows instead of earnings 2. NPV uses all the cash flow projects 3. NPV discounts the all cash flows properly The net present value (NPV) is computed as the present value of the project cash flows minus the cost of the project. If NPV is negative, the present value of the cash flows from the project is less than the cost of the project i.e., it would be cheaper to generate the cash flows by investing at the required rate than by undertaking the project. Since the cash flows could be created more cheaply by investing at the required rate, the project rate of return is below the required rate, and rejection is indicated. Alternately stated, rejecting the project and investing the cost of the project elsewhere would create larger cash flows than accepting the project. Where NPV is positive, it is cheaper to generate the cash flows by undertaking the project than by investing at the required rate of return i.e, the project rate of return is greater than the required return, and acceptance is indicated. Alternately stated, investing the project creates larger cash flows than investing elsewhere. NPV is sometimes described as the change in the value of the firm if the project is accepted. 5.)SOL: CALCULATION OF NPV FOR PROJECT “S”: GIVEN: Cash flows Wacc: 6.00% YEARS CF wacc 6% cf 0 1025 1 -1025 1 380 0.943396 358.4906 2 380 0.889996 338.1986 3 380 0.839619 319.0553 4 380 0.792094 300.9956 1316.74 -291 Where as Cf = cash flows Wacc = weighted average cost of capital CALCULATION OF NPV FOR PROJECT “L”: YEARS CF WACC 6% cf 0 -2150 1 -2150 1 765 0.9346 714.969 2 765 0.8734 668.151 3 765 0.8396 642.294 4 765 0.7921 605.9565 2631.371 -481.371 CORRECT OPTION IS B

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