A company is in the process of evaluating a major product line expansion. Using a 14% discount rate the firm has calculated the present value of both the project’s cash inflows and cash outflows to be $15.8 million. The company will likely evaluate this project further by
Answer (D) is correct. The discount rate at which a project’s discounted net cash inflows equal its discounted net cash outflows is referred to as the internal rate of return (IRR). At this discount rate the project’s net present value is $ . To determine whether a project with a certain IRR is acceptable, this rate of return must be compared with the firm’s current cost of capital and its hurdle rate i.e. the rate of return that management has chosen as the benchmark for acceptable projects.
With regard to a capital investment project, which one of the following statements best describes the relationship between the cost of capital and the expected internal rate of return?
Answer (A) is correct. If the IRR is higher than the company’s desired rate of return cost of capital then the investment is desirable. A company will not accept a project with an IRR that is less than the cost of capital.
The primary advantage of using the internal rate of return (IRR) method to evaluate capital budgeting projects is that it
Answer (C) is correct. The IRR is easy to understand and communicate. Essentially, if the IRR is higher than the company’s desired rate of return then the investment is desirable.
A company invested $500,000 in a new project. The project is expected to yield annual incremental cash flows of $175,000 for 4 years. What is the approximate internal rate of return (IRR) for this project?
Answer (B) is correct. The IRR of an investment is the discount rate at which the investment’s NPV equals 0. In other words, it is the rate that makes the present value of the expected cash inflows equal the present value of the expected cash outflows. The PV factor of an annuity at 15% for a period of 4 years is equal to 2.855 ($175,000 × 2.855 = $499,625, which is about $500,000). Therefore, 15% is the IRR because the NPV would equal $0 ($500,000 – $500,000)
One disadvantage of using internal rate of return (IRR) is that it
Answer (B) is correct. The IRR may not be used when cash flows vary from positive to negative in different years. When the direction of the cash flows changes, focusing simply on IRR can be misleading. This effect is known as the multiple IRR problem. Essentially, there are as many solutions to the IRR formula as there are changes in the direction of the net cash flows.
Assume that an investment project’s assumed cash flows are not changed but the assumed weighted-average cost of capital is reduced. What impact would this have on the net present value (NPV) and the internal rate of return (IRR) of this project?
Answer (D) is correct. If the cost of capital is reduced, the PV factors are increased. This would result in a higher discounted cash inflow each year, resulting in a higher NPV. However, because the project’s assumed cash flows are not changed the IRR will not change. The IRR is the rate that makes the present value of the expected cash inflows equal the present value of the expected cash outflows.
The net present value (NPV) and the internal rate of return (IRR) capital budgeting methods make assumptions about the reinvestment rate of cash inflows over the life of the project. Which one of the following statements is correct with respect to this reinvestment rate of cash inflows?
Answer (C) is correct. Under NPV and IRR, the reinvestment rate is the cost of capital rate and the internal rate of return, respectively.
Which one of the following statements is correct regarding the net present value (NPV) and the internal rate of return (IRR) approaches to capital budgeting?
Answer (A) is correct. If the IRR of a project is equal to the company’s cost of capital the NPV of the project must be 0.
eGoods is an online retailer. The management of eGoods is interested in purchasing and installing a new server for a total cost of $150,000. The controller of eGoods has asked an accountant at eGoods to determine the incremental yearly tax savings should the new server be acquired. The server has an estimated usable life of approximately 4 years and no salvage value. eGoods currently uses straight-line depreciation and is assessed an effective income tax rate of 40%. The accountant should calculate the incremental yearly tax savings to be
Answer (A) is correct. The server will be depreciated $37,500 yearly ($150,000 ÷ 4). Thus, the incremental yearly tax savings is $15,000 ($37,500 × 40%).
Mega Power estimates that the cost to decommission its nuclear power plant in today’s dollars is $500 million. This cost is expected to escalate at 5% per year over the life of the plant. Mega must collect a constant amount each year from customers over the remaining 20-year life of the plant and place the amounts in a fund that is expected to earn at a rate of 7% per year. The fund currently has a balance of $100 million. How much must Mega collect from customers each of the next 20 years to cover the decommissioning costs? Ignore income tax effects and round to millions.
Answer (C) is correct. The first step is to determine the amount that will be needed in 20 years. If the $500
million increases by 5% annually, the amount needed in 20 years would be $1,326,500,000 ($500 million × 2.653). Since there is already $100 million available in the fund, that amount will grow at 7% annually for 20 years to equal $387 million. Subtracting the $387 million from $1,326,500,000 leaves $939,500,000 to be raised. Use a present value table to find the present value of 20 equal payments that will accumulate to $939,500,000 in 20 years at 7% interest. Dividing the $939,500,000 by the future value factor of 40.995 (20 years at 7%) equals $22,917,429 per year, or approximately $23 million.