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Unformatted text preview: ery time period, the NPV of Project B will be twice the NPV of Project A. 9. Although the profitability index (PI) is higher for Project B than for Project A, Project A should be chosen because it has the greater NPV. Confusion arises because Project B requires a smaller investment than Project A. Since the denominator of the PI ratio is lower for Project B than for Project A, B can have a higher PI yet have a lower NPV. Only in the case of capital rationing could the company’s decision have been incorrect. Project A would have a higher IRR since initial investment for Project A is less than that of Project B, if the cash flows for the two projects are identical. Yes, since both the cash flows as well as the initial investment are twice that of Project B. 10. a. b. 11. Project B’s NPV would be more sensitive to changes in the discount rate. The reason is the time value of money. Cash flows that occur further out in the future are always more sensitive to changes in the interest rate. This sensitivity is similar to the interest rate risk of a bond. 12. The MIRR is calculated by finding the present value of all cash outflows, the future value of all cash inflows to the end of the project, and then calculating the IRR of the two cash flows. As a result, the cash flows have been discounted or compounded by one interest rate (the required return), and then the interest rate between the two remaining cash flows is calculated. As such, the MIRR is not a true interest rate. In contrast, consider the IRR. If you take the initial investment, and calculate the future value at the IRR, you can replicate the future cash flows of the project exactly. 112 13. The statement is incorrect. It is true that if you calculate the future value of all intermediate cash flows to the end of the project at the required return, then calculate the NPV of this future value and the initial investment, you will get the same NPV. However, NPV says nothing about reinvestment of intermediate cash flows. The NPV is the present value of the project cash flows. What is actually done with those cash flows once they are generated is not relevant. Put differently, the value of a project depends on the cash flows generated by the project, not on the future value of those cash flows. The fact that the reinvestment “works” only if you use the required return as the reinvestment rate is also irrelevant simply because reinvestment is not relevant in the first place to the value of the project. One caveat: Our discussion here assumes that the cash flows are truly available once they are generated, meaning that it is up to firm management to decide what to do with the cash flows. In certain cases, there may be a requirement that the cash flows be reinvested. For example, in international investing, a company may be required to reinvest the cash flows in the country in which they are generated and not “repatriate” the money. Such funds are said to be “blocked” and reinvestment becomes relevant because the cash flows are not truly available. 14. The statement is incorrect. It is true that if you calculate the future value of all intermediate cash flows to the end of the project at the IRR, then calculate the IRR of this future value and the initial investment, you will get the same IRR. However, as in the previous question, what is done with the cash flows once they are generated does not affect the IRR. Consider the following example: Project A C0 –$100 C1 $10 C2 $110 IRR 10% Suppose this $100 is a deposit into a bank account. The IRR of the cash flows is 10 percent. Does the IRR change if the Year 1 cash flow is reinvested in the account, or if it is withdrawn and spent on pizza? No. Finally, consider the yield to maturity calculation on a bond. If you think about it, the YTM is the IRR on the bond, but no mention of a reinvestment assumption for the bond coupons is suggested. The reason is that reinvestment is irrelevant to the YTM calculation; in the same way, reinvestment is irrelevant in the IRR calculation. Our caveat about blocked funds applies here as well. Solutions to Questions and Problems NOTE: All endofchapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. a. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the initial investment. Project A: Cumulative cash flows Year 1 = $6,500 Cumulative cash flows Year 2 = $6,500 + 4,000 = $6,500 = $10,500 113 Companies can calculate a more precise value using fractional years. To calculate the fractional payback period, find the fraction of year 2’s cash flows that is needed for the company to have cumulative undiscounted cash flows of $10,000. Divide the difference between the initial investment and the cumulative undiscoun...
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 Spring '10
 eshmalwi
 Finance, Corporate Finance

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