Principles of Managerial Finance (14th Edition) (Pearson Series in Finance)
Principles of Managerial Finance (14th Edition) (Pearson Series in Finance)
14th Edition
ISBN: 9780133507690
Author: Lawrence J. Gitman, Chad J. Zutter
Publisher: PEARSON
Question
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Chapter 10, Problem 1OR

a)

Summary Introduction

To determine: The cost of capital of the project.

Introduction:

The difference between the present value of cash inflows and the present value of cash outflows over a period of time is known as the Net Present value.

a)

Expert Solution
Check Mark

Explanation of Solution

Given information:

The initial investment for the project is $83,600,000 and it creates an annual cash inflow of $18,800,000 for 12 years. The project NPV is $66,000,000 and the IRR is 20%.

It is given that the IRR must be less than 20%. However, it is given as 20%. Thus, the NPV will become zero.

Hence, Company S should discount the cash flows at less than 20%, as the NPV is positive.

b)

Summary Introduction

To determine: The cost of capital of the firm.

Introduction:

The difference between the present value of cash inflows and the present value of cash outflows for a particular period is known as the Net Present value. Cost of capital is the cost of long term financing of the firm.

b)

Expert Solution
Check Mark

Explanation of Solution

Given information:

The initial investment for the project is $83,600,000 and it generates an annual cash inflow of $18,800,000 for 12 years. The project NPV is $66,000,000 and the IRR is 20%.

 Explanation:

When the initial investment I0, annual cash flow (AC), rate of interest r, and the time period n is given NPV can be calculated using the below equation:

NPV=AC((1+r)n1)r(1+r)nI0

By trial and error method let us assume the cost of capital to be 0.07.

NPV=18,800,000(((1+0.07)121)0.07(1+0.07)12)83,600,000=(18,800,000×7.942686)83,600,000=149,322,502.483,600,000=65,722,502.38

When substituting 11%, NPV is $65,722,502.38. The NPV is nearly equal to the given NPV $66,000,000. Thus, cost of capital of the firm is 7% (approximately).

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Chapter 10 Solutions

Principles of Managerial Finance (14th Edition) (Pearson Series in Finance)

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