parts used in the after-market with products from GM, Ford, and other auto maker

Question

parts used in the after-market with products from GM, Ford, and other auto makers. Your

boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed

projects. Project L involves adding a new item to the firm’s ignition system line; it would

take some time to build up the market for this product, so the cash inflows would increase over

time. Project S involves an add-on to an existing line, and its cash flows would decrease over

time. Both projects have 3-year lives, because Axis is planning to introduce entirely new models

after 3 years.

Here are the projects’ net cash flows (in thousands of dollars):

Expected Net Cash Flow

0                     ($100)                       ($100)

1                    10                                70

2                      60                               50

in these cash flows.

The CFO also made subjective risk assessments of each project, and he concluded that both

projects have risk characteristics which are similar to the firm’s average project. Axis’s weighted

average cost of capital is 10 percent. You must now determine whether one or both of the projects

(3) Would the NPVs change if the cost of capital changed?

e. (1) Define the term

(2) How is the IRR on a project related to the YTM on a bond?

(3) What is the logic behind the IRR method? According to IRR, which projects should be

accepted if they are independent? Mutually exclusive?

(4) Would the projects’ IRRs change if the cost of capital changed?

f. (1) Draw NPV profiles for Projects L and S. At what discount rate do the profiles cross?

(2) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which

project or projects should be accepted if they are independent? Mutually exclusive?

Explain. Are your answers correct at any cost of capital less than 23.6 percent?

g. (1) What is the underlying cause of ranking conflicts between NPV and IRR?

(2) What is the “reinvestment rate assumption,” and how does it affect the NPV versus IRR

conflict?

(3) Which method is the best? Why?

h. (1) Define the term

(2) What are the MIRR’s advantages and disadvantages vis-à-vis the regular IRR? What are

the MIRR’s advantages and disadvantages vis-à-vis the NPV?

i. As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcoming

World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5

Explanation / Answer

Observe that yes NPV is highly depenent on the cost of capital. As the cost of capital increases the value of cash flow also decreases as there exists a inverse relationship between the npv and cash flows.

And as the cost of capital decreases the value of future cash flows also decreases.

2).

IRR is the internal rate of return at which the npv is 0.

3).

IRR is independent of the return of the stock. Therefore if a higher return is expected from the project the project whose IRR is greater than the cost of capital is selected since the cost of capital should be recovered.

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