# Capital Budgeting : NPW and IRR methods

Problem 1

A firm has the following investment alternatives. Each one lasts a year.

Investment A B C

Cash inflow $1,150 $560 $600

Cash outflow $1,000 $500 $500

The firm's cost of capital is 7 percent. A and B are mutually exclusive, and B and C are mutually exclusive.

a. What is the net present value of investment A? Investment B? Investment C?

b. What is the internal rate on investment A? Investment B? Investment C?

c. Which investment(s) should the firm make? Why?

d. If the firm had unlimited sources of funds, which investment(s) should it make? Why?

e. If there were 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 of return?

Problem 2

If the cost of capital is 9 percent and an investment costs $56,000, should you make this investment if the estimated cash flows are $5,000 for years 1 through 3, $10,000 for years 4 through 6, and $15,000 for years 7 through 10?

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#### Solution Preview

Problem 1

a. What is the net present value of investment A? Investment B? Investment C?

Project A

Cash outflow=Co=-$1000

Cash inflow=C1=$1150

Cost of capital=r=7%

NPV of project A=Co+C1/(1+r)^1=-1000+1150/(1+7%)^1=$74.77

Project B

Cash outflow=Co=-$500

Cash inflow=C1=$560

Cost of capital=r=7%

NPV of project A=Co+C1/(1+r)^1=-500+560/(1+7%)^1=$23.36

Project C

Cash outflow=Co=-$500

Cash inflow=C1=$600

Cost of capital=r=7%

NPV of project A=Co+C1/(1+r)^1=-500+600/(1+7%)^1=$60.75

b. What is the internal rate on investment A? Investment B? Investment C?

Project A

Let IRR be r

At IRR, NPV will be equal to ...

#### Solution Summary

Solution describes the steps to determine if the given proposals are worth investing.