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Problems with Net Present Value

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Project C0 C1 C2 C3 C4 C5 Etc. IRR (%) NPV at 10%
F -9000 6000 5000 4000 0 0 ... 33 3592
G -9000 1800 1800 1800 1800 1800 ... 20 9000
H -6000 1200 1200 1200 1200 ... 20 6000

Look back to the cash flows for projects F and G in Section 5-3, the cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are overstated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects' sponsors, instructs them to use a discount rate of 18%.

a. What are the projects' true NPVs?
b. What are the NPVs at the 18% discount rate?
c. Are there any circumstances in which the 18% discount rate would give the correct NPV?

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This solution helps with problems involving net present values.

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Project C0 C1 C2 C3 C4 C5 Etc. IRR(%) NPV at 10%
F -9000 6000 5000 4000 0 0 ... 33 3592
G -9000 1800 1800 1800 1800 1800 ... 20 9000
H -6000 1200 1200 1200 1200 ... 20 6000

Look back to the cash flows for projects F and G in Section 5-3, The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are overstated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects' sponsors, instructs them to use a discount rate of 18%.
a. What are the projects' true NPVs?
To cash flows are overstated by 8%, so we need to reduce the cash flows by 8% to get the true cash flows. The cash flows now would be 92% of the earlier cash flows and ...

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