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Corporate Finance Problems on NPV and IRR

1) Under what conditions does r, a stock's market capitalization rate, equal its earnings price ratio EPS1/P0?

2) What is meant by the "horizon value" of a business? How can it be estimated?

3) Respond to the following comments:
a. "I like the IRR rule. I can use it to rank projects without having to specify a discount rate."
b. "I like the payback rule. As long as the minimum payback period is short, the rule makes sure that the company takes no borderline projects. That reduces risk."

4) Some people believe firmly, even passionately, that ranking projects on IRR is OK if each project's cash flows can be reinvested at the project's IRR. They also say that the NPV rule "assumes that cash flows are reinvested at the opportunity cost of capital." Think carefully about these statements. Are they true? Are they helpful?

5) Mr. Art Deco will be paid $100,000 one year hence. This is a nominal flow, which he discounts at an 8% nominal discount rate: PV = 100,000/1.08 = $92,593
Also, the inflation rate is 4%. Calculate the PV of Mr. Deco's payment using the equivalent real cash flow and real discount rate. (You should get exactly the same answer as he did.)

6) Each of the following statements is true. Explain why they are consistent.
a. When a company introduces a new product, or expands production of an existing product, investment in net working capital is usually an important cash outflow.
b. Forecasting changes in net working capital is not necessary if the timing of all cash inflows and outflows is carefully specified.

Solution Preview

1) r= Div 1/ Po +g.
However, if the earnings do not grow at all, then g =0. This will happen when the firm does not plowback any part af its earnings - pays out all earnings as dividends. So, Div 1 = EPS 1, g=0 and r= EPS1/P0.

2) Horizon value is the value of the business at valuation horizon. The value of a business is calculated as the discounted value of free cash flows up to a valuation horizon, and to this value is added the forecasted value of the business at the horizon (called the horizon value), discounted back to present time. It can be estimated using P/E Ratios or Market Price/Book Value ratios.

3) a) The IRR rule requires that, for a project to be selected, the IRR for the project is greater than the firm's opportunity cost of capital. So, there is no escaping specifying a discount rate - the discount rate with which the firm's IRR is to be ...

Solution Summary

Answers to 6 Corporate Finance Questions dealing with stock's market capitalization rate, horizon value of a business, IRR, time value of money etc.