There are times when comparing two projects that the IRR and NPV techniques resu

Question

There are times when comparing two projects that the IRR and NPV techniques result in conflicting rankings. For example, the IRR of project B may be higher than the IRR of project A while the NPV of project A is greater than the NPV of project B. What could cause this? On what basis should the decision be made? Explain. You are considering the purchase of shares of stock in ABC Company which just paid its annual dividend of $4.00 per share. You believe that its dividend will not be increased or decreased for the next four years, but will be increased at the constant rate of 5% per year beginning in year five and thereafter. If you require a rate of return of 10% on any investment in ABC stock, what should you be willing to pay for the stock today? Show your work. Assume that you buy a $1,000 face value bond which has a coupon rate of 10% and is paid annually and has 20 years until it matures. You purchase the bond when the market rate of interest on all maturities is 5 percent. Further assume that you hold the bond for five years at which time you sell the bond. At the time you sell the bond the market rate of interest on all maturities is 8 percent. What rate of return did you earn on your investment in the bond? Show your work. You buy a machine at a cost of $100,000. It is expected to be useful for 10 years You will depreciate the machine over the 10 years using the straight-line basis, ignoring for depreciation purposes the estimated salvage value which you estimate to be $2,000. The machine is expected to generate revenues of $15,000 per year and at the same time reduce cash costs by $3,000 per year. The increase in sales is expected to require that the firm increase its investment in working capital by $5,000 as soon as the machine is purchased. If the firm has a cost of capital of 9 percent and a tax rate of 30 percent, is this a good investment? Show your work.

Explanation / Answer

Bond Price = C * [1-1/(1+i)^n] / i + M /(1+i)^n

C = Coupon Payment = 1000 * 10% = $100

i = market rate = 5%

n = 20 years

M = Maturity Value = $1000

Bond Price = 100 * [1-1/(1+.05)^20] / .05 + 1000 /(1+.05)^20

= $1246.22 + $376.89 = $1623.11

Purchase Price of Bond = $1623.11

After 5 years bond price (i = 8%) =

Bond Price = 100 * [1-1/(1+.08)^15] / .08 + 1000 /(1+.08)^15

= $855.95 + $315.24 = $1171.19

Sale Price of Bond = $1171.19

There is a loss. % loss = (1623.11 - 1171.19) / 1623.11 * 100 = -27.84%

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