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Unformatted text preview: University of Texas at Dallas School of Management Finance 6301 Professor Day Corporate Finance Fall 2010 Solution Set 4 1. Discuss the validity of the following argument. “Since the internal rate of return for a capital investment project does not depend on the required rate of return, the Internal Rate of Return rule is preferable to the Net Present Value rule.” The internal rate of return for a capital investment project can be computed simply by finding a discount rate (sometimes there are two or three) that makes the present value of the future cash inflows equal to the present value of the current and future cash outflows. However, although the computation of the internal rate of return does not depend on the required rate of return, the use of the internal rate of return as an investment decision rule calls for accepting projects having an internal rate of return greater then the required rate of return and rejecting projects having an internal rate of return that is less than the required rate of return. Therefore, the implementation of the internal rate of return rule in investment decision-making requires that a required rate of return (or opportunity cost of capital) be established as a standard of comparison. 2. Lurie Steel plans to build a factory in Prue, Oklahoma to manufacture and sell custom steel products. The new facility requires an initial investment of $90 million. Over the next seven years, Lurie plans to reinvest 100 percent of the free cash flow from the project to expand production capacity at the Prue plant. Assuming that Lurie expects to sell the steel plant for $220 million at the end of seven years, determine the Internal Rate of Return for the project. In this particular example, the discount rate (the Internal Rate of Return) that makes the Net Present Value of the investment equal to zero is the solution to 0 = < $90 > + $220 (1 + IRR) 7 , Rearranging the zero Net Present Value condition above and solving for the IRR gives IRR = $220 $90 7 = 0.1362 (13.62 percent) 2 3. B.B. Braswell, CFO for the Braswell Company, is considering proposals to invest in two mutually exclusive projects. Project A, which requires an immediate investment of $10,000 , will generate cash inflows of $5047 at the end of each of the next three years. Project B also requires an initial investment of $10,000 . However, project B will generate perpetual year- end cash inflows of $2200 . B.B. believes that project A is superior to project B, since project A has an IRR of 24 percent whereas the IRR for project B is only 22 percent. a. Assuming that the opportunity cost of capital is 12 percent, which project should the Braswell Company invest in?...
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This note was uploaded on 01/23/2011 for the course FIN 6301 taught by Professor El-asmawanti during the Fall '09 term at University of Texas at Dallas, Richardson.
- Fall '09
- Corporate Finance