chap05_newsol

# Fundamentals of Corporate Finance + Standard & Poor's Educational Version of Market Insight

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CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria Answers to Practice Questions 1. a. \$90.91 .10) (1 \$1000 1000 NPV A - = + - = \$ \$4,044.73 10) (1. \$1000 (1.10) \$1000 (1.10) \$4000 (1.10) \$1000 (1.10) \$1000 2000 NPV 5 4 3 2 B + = + + + + + - = \$ \$39.47 10) (1. \$1000 .10) (1 \$1000 (1.10) \$1000 (1.10) \$1000 3000 NPV 5 4 2 C + = + + + + - = \$ b. Payback A = 1 year Payback B = 2 years Payback C = 4 years c. A and B 2. a. When using the IRR rule, the firm must still compare the IRR with the opportunity cost of capital. Thus, even with the IRR method, one must specify the appropriate discount rate. b. Risky cash flows should be discounted at a higher rate than the rate used to discount less risky cash flows. Using the payback rule is equivalent to using the NPV rule with a zero discount rate for cash flows before the payback period and an infinite discount rate for cash flows thereafter. 3. r = -17.44% 0.00% 10.00% 15.00% 20.00% 25.00% 45.27% Year 0 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 Year 1 3,500.00 4,239.34 3,500.00 3,181.82 3,043.48 2,916.67 2,800.00 2,409.31 Year 2 4,000.00 5,868.41 4,000.00 3,305.79 3,024.57 2,777.78 2,560.00 1,895.43 Year 3 -4,000.00 -7,108.06 -4,000.00 -3,005.26 -2,630.06 -2,314.81 -2,048.00 -1,304.76 PV = -0.31 500.00 482.35 437.99 379.64 312.00 -0.02 The two IRRs for this project are (approximately): –17.44% and 45.27% Between these two discount rates, the NPV is positive. 28

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4. a. The figure on the next page was drawn from the following points: Discount Rate 0% 10% 20% NPV A +20.00 +4.13 -8.33 NPV B +40.00 +5.18 -18.98 b. From the graph, we can estimate the IRR of each project from the point where its line crosses the horizontal axis:
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chap05_newsol - CHAPTER 5 Why Net Present Value Leads to...

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