10. This problem tests your understanding of the chapter appendix. A company is
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10. This problem tests your understanding of the chapter appendix. A company is considering the following investment opportunities Investment Initial cost ($millions) Expected life NPV @ 15% IRR 5.5 10 yrs $340,000 $300,000 $200,000 20% 3.0 10 yrs. 2.0 10 yrs. 3096 40% a. If the company can raise large amounts of money at an annual cost of 15 percent, and if the investments are independent of one an- other, which should it undertake? b. If the company can raise large amounts of money at an annual cost of 15 percent, and if the investments are mutually exclusive, which should it undertake? c. Considering only these three investments, if the company has a fixed capital budget of $5.5 million, and if the investments are in- dependent of one another, which should it undertake?Explanation / Answer
The cost of funds for the company is 15%.
In a project,if the IRR ( internal rate of return) is greater than the cost of funds, the project be selected.
a) if the company can raise large amounts of money and if investments are independent of one another, the company should pursue all the three projects.
We assume that the projects are all having similar risks and cash flow patterns.
b) if the projects are mutually exclusive, it implies that only one of them can be selected. Therefore in this case the company should undertake the investment with the highest internal rate of return IRR I.e. investment C.
c) if the company has a fixed capital budget of $5.5 million, the company should select investment A, which has the highest net present value NPV, amongst the three investment proposals
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