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Company Risk versus Project Risk [LO5] Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both companies are all equity financed. Dow and Superior are looking at identical projects. They’ve analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their projects would have a
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Chapter 14 Solutions
EBK FUNDAMENTALS OF CORPORATE FINANCE A
- A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 6.00% Year 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 $198.61 $219.51 $209.07 O $188.67 $230.55arrow_forwardA firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 6.75% 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 Please explain and show calculations.arrow_forwardA firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure, given a WACC of 15%. If the wrong decision criterion is used, how much potential value would the firm lose? Project Year 0 Year 1 Year 2 Year 3 Year 4 S -$995 million $385 million $400 million $525 million $650 million L -$2.05 billion $705 million $835 million $950 million $1.025 billion $6.04 million O $359.08 million $46.04 million $451.15 million O $405.11 millionarrow_forward
- A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 5.29 % 0 1 2 3 4 CFS -$ 1,036 $380 $380 $380 $380…arrow_forwardYonan Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost. WACC: 10.25% 0 1 2 3 4 CFS -$800 $650 $350 $0 $0 CFL -$1,900 $550 $600 $600 $840 Please explain and show calculations.arrow_forward17. Nast Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause S0.00 value to be lost. WACC: 10.50% 1 2 3 CFs -S1,100 $375 $375 $375 $375 CFL -$2,200 $725 $725 $725 $725 a. $2.33 b. $1.91 c. $0.00 d. S2.77 e. $2.11 18. Margetis Inc. carries an average inventory of $750,000. Its annual sales are $10 million, its cost of goods sold are 75% of annual sales, and its receivables collection period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays on time. Its new CFO wants to decrease the cash conversion cycle by 18 days, based on a 365-day year. He believes he can reduce the average inventory to $613,739 with no effect on…arrow_forward
- Risk and NPV; Sensitivity Analysis J. Morgan of SparkPlug Inc. has been approached to takeover a production facility from B.R. Machine Company. The acquisition will cost $1,500,000, andthe after-tax net cash inflow are expected to be $275,000 per year for 12 years.SparkPlug currently uses 12% for its after-tax cost of capital. Tom Morgan, production manager,is very much in favor of the investment. He argues that the total after-tax net cash inflow is more thanthe cost of the investment, even if the demand for the product is somewhat uncertain. “The project willpay for itself even if the demand is only half the projected level.” Cindy Morgan (corporate controller)believes that the cost of capital should be 15% because of the declining demand for SparkPlug products.Required1. What is the estimated NPV of the project if the after-tax cost of capital (discount rate) is 12%? Use thebuilt-in NPV function in Excel; round your answer to the nearest whole dollar. 2. What is the estimated NPV of…arrow_forward2. Nast Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost. WACC: 8.00% 1 2 3 4 CFS -$1,100 $375 $375 $375 $375 CFL -$2,200 $725 $725 $725 $725 a. $50.95 b. $66.95 c. $59.24 d. $47.40 e. $72.28arrow_forwardPart 1: The CFO of Cruz, inc. is considering Projects A and B which are considered equally risky; the projected cash flows for the projects are shown below. T= 0 1 2 3 4 Project A (14,500) 9,900 4,500 4,500 3000 Project B (14,250) 5,250 5,250 5,250 7,500 1. what is the "crossover rate" for the two projects? Show the difference between the two projects' timeline in the space above. round your answer to the nearest tenth of a percent 2. Provide the NPV's for both A and B at the rates in the table below. Round to the nearest dollar/whole number. Interest Rate NPV project A NPV project B 0% 6% 12% 18% 24% 3. Provide the IRR for each project in the table below. show each rate to the nearest tenth of a percent. Project A IRR? Project B IRR? 4. Calculate the MIRR for project A, and B using a WACC (discount rate). use the "combination approach" by finding the future values(show your…arrow_forward
- Part 1: The CFO of Cruz, inc. is considering Projects A and B which are considered equally risky; the projected cash flows for the projects are shown below. T= 0 1 2 3 4 Project A (14,500) 9,900 4,500 4,500 3000 Project B (14,250) 5,250 5,250 5,250 7,500 1. what is the "crossover rate" for the two projects? Show the difference between the two projects' timeline in the space above. round your answer to the nearest tenth of a percent 2. Provide the NPV's for both A and B at the rates in the table below. Round to the nearest dollar/whole number. Interest Rate NPV project A NPV project B 0% 6% 12% 18% 24% 3. Provide the IRR for each project in the table below. show each rate to the nearest tenth of a percent. Project A IRR? Project B IRR? 4. Calculate the MIRR for project A, and B using a WACC (discount rate). use the "combination approach" by finding the future values(show your…arrow_forwardFinance Companies A and B are each considering an unanticipated new investment opportunity that will marginally increase the value of the company and will also increase the company’s level of diversication. Company A is unlevered, and company B has a capital structure of 50% debt. Assume that the shareholders control the company, which one of the following statements is correct. a) Since NPV of the investment is positive both company A and B will accept the project. b) Since the project only marginally increase company values but decreases return variance of the company’s assets both companies will reject the project. c) It is more obvious that Company B invests since for levered company the diversication benefits are more important. d) None of the given alternative.arrow_forwardA firm is considering two investment projects, Y and Z. These projects are NOT mutually exclusive. Assume the firm is not capital constrained. The initial costs and cashflows for these projects are: 0 1 2 3 Y -40,000 17,000 17,000 15,000 Z -28,000 12,000 12,000 20,000 Using a discount rate of 9% calculate the net present value for each project. What decision would you make based on your calculations? How would your decision change if the discount rate used for calculating the net present value is 15%? Calculate an approximate IRR for each project. Assume the hurdle rate is 9%. What decision would you make based on your calculations? Calculate the payback period for each project. The company looks to select investment projects paying back in 2 years. What decision would you make based on your calculations? Critically discuss Net Present Value (NPV), Internal Rate of Return (IRR) and payback period as criteria for investment appraisal.arrow_forward