Capital budgeting problems and what king of you used for solving (NPV and IRR PROBLEMS )
A firm has the following investment alternative. Each one lasts a year
Investment A B C
Cach inflow $1,150 $560 $600
Cash outflow $1000 $500 $500
The firm's cost capital 7 percent. A and B are mutually exclusive, and B and C are mutually exclusive.
d. If the firm had unlimited sources of funds, which investments should it make? Why?
e. If there another alternative, investment D, with an internal rate of return of 6 percent, would that alter your anser to question (d)? why?
f. If the firm's cost of capital rose to 10 percent, what effect would that have on investment A's internal rate return?
All the financials in this solution are in $. Figures in parenthesis mean negative values.
Based on the cash flows and cost of capital, let's first calculate th NPV and IRR of each of the projects. Please see the leftmost column. Formula to calculate NPV and IRR is also given.
Investment | A | B | C |
Cash Inflow (P) | 1,150 | 560 | 600 |
Cash Outflow (Q) | 1,000 | 500 | 500 |
Cost of capital (R ) | 7% | 7% | 7% |
NPV = -Q + P / (1 + R) | 74.77 | 23.36 | 60.75 |
IRR = P / Q - 1 | 15.00% | 12.00% | 20.00% |
Part (d)
All the three projects have positive NPV and all of them have IRR > Cost of capital. Hence, all of them are eligible projects. However, A and B are mutually exclusive, and B and C are mutually exclusive.
Hence between A & B, only one can be selected. Between B & C, only one can be selected.
Based on NPV, between A & B, A has higher NPV. Hence A should be selected. Between B & C, C has higher NPV and hence C should be selected.
If the firm had unlimited sources of funds, it should make investments A & C.
Part (e)
If there another alternative, investment D, with an internal rate of return of 6 percent, that would not alter our anser to question (d). This is beca...
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