chap006

# If c0 0 and all future cash flows are positive reject

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Unformatted text preview: ows are positive, reject the project if IRR < discount rate. If C0 > 0 and all future cash flows are negative, accept the project if IRR discount rate. If C0 > 0 and all future cash flows are negative, reject the project if IRR > discount rate. If the project has cash flows that alternate in sign, there is likely to be more than one positive IRR. In that situation, there is no valid IRR accept / reject rule. d. The profitability index (PI) is defined as: (The present value of the cash flows subsequent to the initial investment The initial investment) Accept any project for which the profitability index is equal to or greater than one. Reject project for which that is not true. e. The net present value (NPV) is the sum of the present values of all project cash flows. Accept those projects with NPVs which are equal to or greater than zero. Rejects proposals with negative NPVs. 6.18 Let project A represent New Sunday Early Edition; and let project B represent New Saturday Late Edition. a. b. Payback period of project A = 2 + (\$1,200 - \$1,150) / \$450 = 2.11 years Payback period of project B = 2 + (\$2,100 - \$1,900) / \$800 = 2.25 years Based on the payback period rule, you should choose project A. Project A: Average investment = (\$1,200 + \$0) / 2 = \$600 Depreciation = \$400 / year Average income = [(\$600 - \$400) + (\$550 - \$400) + (\$450 - \$400)] / 3 = \$133.33 AAR = \$133.33 / \$600 = 22.22% Project B: Average investment = (\$2,100 + \$0) / 2 = \$1,050 Depreciation = \$700 / year Average income = [(\$1,000 - \$700) + (\$900 - \$700) + (\$800 - \$700)] / 3 = \$200 AAR = \$200 / \$1,050 = 19.05% IRR of project A: -\$1,200 + \$600 / (1 + r) + \$550 / (1 + r)2 + \$450 / (1 + r)3 = 0 IRR = r = 16.76% IRR of project B: -\$2,100 + \$1,000 / (1 + r) + \$900 / (1 + r)2 + \$800 / (1 + r)3 = 0 IRR = r = 14.29% Project A has a greater IRR. c. Answers to End-of-Chapter Problems B-69 d. IRR of project B-A: Incremental cash flows Year 0 B-A -\$900 1 \$400 2 \$350 3 \$350 -\$900 + \$400 / (1 + r) + \$350 / (1 + r)2 + \$350 / (1 + r)3 = 0 Incremental IRR = r = 11.02% If the required rate of return is greater than 11.02%, then choose project A. If the...
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