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Capital Budgeting Investment Decisions

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A firm's cost of capital is 12 percent. The firm has three investments to choose among; the cash inflows of each are as follows:

Cash Inflows
A B C
YEAR 1 395 0 1241
YEAR 2 395 0 0
YEAR 3 395 0 0
YEAR 4 0 1749 0

Each investment requires a $1,000 cash outlay, and investment B and C are mutually exclusive.
(a) Which investment(s) should the firm make according to the net present values? Why?
(b) Which investments(s) should the firm make according to the internal rates of return? Why?
(c) If all funds are reinvested at 15 percent, which investment(s) should the firm make? Would your answer be different if the reinvestment rate were 12 percent?

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Solution Preview

Please refer attached file for better clarity of tables.

(a) Which investment(s) should the firm make according to the net present values? Why?
Project A
Year,n Cash Flow, Cn PV =Cn/(1+12%)^n
0 -1000 -1000.00
1 395 352.68
2 395 314.89
3 395 281.15
4 0 0.00
NPV -51.28

Project B
Year , n Cash Flow, Cn PV =Cn/(1+12%)^n
0 -1000 -1000.00
1 0 0.00
2 0 0.00
3 0 0.00
4 1749 1111.52
NPV 111.52

Project B
Year , n Cash Flow, Cn PV =Cn/(1+12%)^n
0 -1000 -1000.00
1 1241 1108.04
2 0 0.00
3 0 0.00
4 0 0.00
NPV 108.04

Project A has negative NPV, it should be rejected.
Since Project B and Project C are mutually ...

Solution Summary

Solution describes the steps to calculate NPV, IRR and MNPV for each of the given projects. IRR is calculated by using suitable function/s in MS Excel.

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Capital Budgeting and Investment Decisions

1. Find the following values for a lump sum assuming annual compounding:
a). The future value of $599 invested at 8 percent for one year.
b). The future value of $500 invested at 8 percent for five years.
c). The present value of $500 to be received in one year when the opportunity cost rate is 8 percent.
d). The present value of $500 to be received in five years when the opportunity cost rate is 8 percent.

2. Find the following values assuming a regularly, or ordinary, annuity:
a). The present value of $400 per year for ten years at 10 percent.
b). The future value of $400 per year for ten years at 10 percent.
c). The present value of $200 per year for five years at 5 percent.
d). The future value of $200 per year for five years at 5 percent.

3. Consider the following uneven cash flow stream:
Year Cash Flow
0 $ 0
1 250
2 400
3 500
4 600
5 600
a). What is the present (Year 0) value if the opportunity cost (discount) rate is 10 percent.
b). Add an outflow (or cost) of $1,000 at Year 0. What is the present value (or net present
value) of the stream?

4. Consider another uneven cash flow stream:
Year Cash Flow
0 $2,000
1 2,000
2 0
3 1,500
4 2,500
5 4,000
a). What is the present (Year 0) value of the cash flow stream if the opportunity cost rate is 10 percent.
b). What is the value of the cash flow stream at the end of Year 5 if the cash flows are invested in an account that pays 10 percent annually?

5. Assume that you just won $35 million in the Florida lottery, and hence the state will pay you 20 annual payments of $1.75 million each beginning immediately. If the rate of return on securities of similar risk to the lottery earnings (e.g., the rate on 20-year U.S. Treasury bonds) is 6 percent. What would happen to the present value of the perpetuity?

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