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FM11 33 - greater than that hurdle rate both should be...

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Mini Case: 11 - 33 d. 2. How is the IRR on a project related to the YTM on a bond? Answer: The IRR is to a capital project what the YTM is to a bond. It is the expected rate of return on the project, just as the YTM is the promised rate of return on a bond. d. 3. What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive? Answer: IRR measures a project's profitability in the rate of return sense: if a project's IRR equals its cost of capital, then its cash flows are just sufficient to provide investors with their required rates of return . An IRR greater than r implies an economic profit, which accrues to the firm's shareholders, while an IRR less than r indicates an economic loss, or a project that will not earn enough to cover its cost of capital. Projects' IRRs are compared to their costs of capital , or hurdle rates . Since franchises L and S both have a hurdle rate of 10 percent, and since both have IRRs
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Unformatted text preview: greater than that hurdle rate, both should be accepted if they are independent. However, if they are mutually exclusive, franchise S would be selected, because it has the higher IRR. d. 4. Would the franchises' IRRs change if the cost of capital changed? Answer: IRRs are independent of the cost of capital. Therefore, neither IRR S nor IRR L would change if r changed. However, the acceptability of the franchises could change--L would be rejected if r were above 18.1%, and S would also be rejected if r were above 23.6%. e. 1. Draw NPV profiles for franchises L and S. At what discount rate do the profiles cross? Answer: the NPV profiles are plotted in the figure below. Note the following points: 1. The y-intercept is the project's NPV when r = 0% . This is $50 for L and $40 for S. 2. The x-intercept is the project's IRR . This is 18.1 percent for l and 23.6 percent for S....
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