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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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A firm has a $100 million capital budget. It is considering two projects, each costing $100 million. Project A has an IRR of 20% and an NPV of $9 million; it will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30% and an NPV of $50 million. However, the firm’s short-run EPS will be reduced if it accepts Project B because no revenues will be generated for several years.

  1. a. Should the short-run effects on EPS influence the choice between the two projects?
  2. b. How might situations like this influence a firm’s decision to use payback?

a.

Summary Introduction

To explain: Whether the short terms effects on EPS influence the choice between the two projects.

Introduction:

Net Present Value (NPV):

It is a method under capital budgeting which includes the calculation of net present value of the project in which the company is investing. The calculation is done by calculating the difference between the value of cash inflow and value of cash outflow after considering the discounted rate.

Internal Rate of Return (IRR):

It refers to the rate of return that is computed by the company to make a decision regarding the selection of a project for investment. This rate provides the basis for selection of projects with lower cost of capital and rejection of project with higher cost of capital.

Earnings per Share (EPS):

It refers to the per share income of a business that has been earned during a period. It is shareholders earning on the shares they have invested in.

Explanation
  • Since the firms overall motive is to gain as much as possible with the increase in shareholder’s wealth for short term effect on EPS it should not influence into the choice between the two projects...

b.

Summary Introduction

To explain: The way in which the given situation can influence a firm’s decision to use payback.

Introduction:

Payback Period:

It refers to the time period that is required to get an amount invested in a project with some return on it. In other words, it is the time that a project takes to repay the amount invested with some return attached to it.

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