2. The cost of capital for a firm is 10 percent. The firm has two possible investments with the following cash inflows:
Year 1 $300 $200
2 200 200
3 100 200
a. Each investment costs $480. What investment(s) should the firm make according to net present value?
b. What is the internal rate of return for the two investments?
Which investment(s) should the firm make?
Is this the same answer you obtained in part a?
c. If the cost of capital rises to 14 percent, which investment(s) should the firm make?
3) A firm has the following investment alternatives:
A B C
Year 1 $1,100 $3,600 -
2 1,100 - -
3 1,100 - $4,562
Each investment costs $3,000; investments B and C are mutually exclusive, and the firm's cost of capital is 8 percent.
a. What is the net present value of each investment?
b. According to the net present values, which investment(s) should the firm make?
c. What is the internal rate of return on each investment?
d. According to the internal rates of return, which investment(s) should the firm make?
e. According to both the net present values and internal rates of return, which investments should the firm make?
f. If the firm could reinvest the $3,600 earned in year one from investment B at 10 percent, what effect would that information have on your answer to part e?
Would the answer be different if the rate were 14 percent?
g. If the firm's cost of capital had been 10 percent, what would be investment A's internal rate of return?
h. The payback method of capital budgeting selects which investment?
4. The chief financial officer has asked you to calculate the net present values and internal rates of return of two $50,000 mutually exclusive investments with the following cash flows:
Project A Project B
Cash Flow Cash Flow
Year 1 $10,000 $ 0
2 25,000 22,000
3 30,000 48,000
If the firm's cost of capital is 9 percent, which investment(s) would you recommend?
Would your answer be different if the cost of capital were 14 percent?
3. A firm's current balance sheet is as follows:
Assets $100 Debt $10
a. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?
Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?
b. Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with the firm's current balance sheet.
What course of action should the firm take?
Assets $100 Debt $?
c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
d. If a firm uses too much debt financing, why does the cost of capital rise?
The solution, provided in both an Excel and Word attachment, provides a detailed solution to all the problems given above.
The solution provides detailed steps on how to calculate the Net present value, internal rate of return, and payback period.
These techniques are used for evaluating projects and in decision-making. The objective of capital budgeting is to utilize a scarce resource, cash, in the most profitable manner.