FM11 36 - flows are reinvested at the cost of capital. To...

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f. 3. Which method is the best? Why? Answer: Whether NPV or IRR gives better rankings depends on which has the better reinvestment rate assumption. Normally, the NPV's assumption is better. The reason is as follows: a project's cash inflows are generally used as substitutes for outside capital, that is, projects' cash flows replace outside capital and, hence, save the firm the cost of outside capital. Therefore, in an opportunity cost sense, a project's cash
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Unformatted text preview: flows are reinvested at the cost of capital. To see this graphically, think of the following situation: assume the firm's cost of capital is a constant 10% within the relevant range of financing considered, and it has projects available as shown in the graph below: P e r c e n t D o l l a r s R a i s e d a n d I n v e s t e d M C C I R R A = 2 5 % I R R B = 2 0 % I R R C = 1 5 % I R R D = 1 2 % I R R E = 8 % I R R F = 5 % 5 20 25 15 10 Mini Case: 11 - 36...
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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