Capital Budgeting Paper 10

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.

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.

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.

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)

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.

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.

Answer (C) is correct. Under NPV and IRR, the reinvestment rate is the cost of capital rate and the internal rate of return, respectively.

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.

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%).

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 x 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.