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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

NPV PROFILES: SCALE DIFFERENCES A company is considering two mutually exclusive expansion plans. Plan A requires a $40 million expenditure on a large-scale integrated plant that would provide expected cash flows of $6.4 million per year for 20 years. Plan B requires a $12 million expenditure to build a somewhat less efficient, more labor-intensive plant with expected cash flows of $2.72 million per year for 20 years. The firm’s WACC is 10%.

  1. a. Calculate each project’s NPV and IRR.
  2. b. Graph the NPV profiles for Plan A and Plan B and approximate the crossover rate.
  3. c. Calculate the crossover rate where the two projects’ NPVs are equal.
  4. d. Why is NPV better than IRR for making capital budgeting decisions that add to shareholder value?

a.

Summary Introduction

To calculate: The NPV and IRR of Project A and Project B.

Introduction:

Mutually Exclusive Projects:

It refers to the group of projects in which, if one project is accepted it will automatically imply the rejection of rest. It refers to those projects for which investment cannot be made together.

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.

Explanation

Given information:

Cost of project A is $40 million.

Life of project A is 20 years.

Cash inflow expected from Plan A per year is $6.4 million.

Cost of Plan B is $12 million.

Life of the Plan B is 20 years.

Cash inflow expected from Plan B is per year $2.72 million.

Cost of capital of the two plans is 10%.

The calculation of NPV and IRR for Project A on spreadsheet,

b.

Summary Introduction

To prepare: The NPV profiles of the two plans and the crossover rate.

Introduction:

Crossover Rate:

It refers to that discounted rate at which the NPV of the two projects becomes equal. It is a cost of capital of the project.

c.

Summary Introduction

To calculate: Crossover rate of the two plans.

d.

Summary Introduction

To explain: The reason of NPV being better than IRR for capital budgeting decisions.

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