We can also calculate the cost of capital equity as

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that the IRR is equal to the cost of capital (cost of equity in this case) so 12%. We can also calculate the cost of capital (equity) as 12% by using the second project. b. Increasing the cost of equity would lower the present value of the future cash flows for both projects. This would lower the NPV of both of them. The $0 NPV project would become negative (so rejected). The positive NPV project would become lower. If still positive it would be accepted, if it becomes negative, rejected. Changing the cost of equity would have no impact on the IRR (since the cash flows are not affected). The increasing cost of equity, however, would similarly make project 1 undesirable because the IRR < cost of equity, and for project 2 the result is ambiguous because we would need to know how much higher the cost of equity is to know what it is relative to the IRR of 17.65%. 2. A lowering of the corporate tax rate increases the future after-tax cash flows. This would increase the NPV and IRR of both projects. Project 1 would now have a positive NPV and an IRR > cost of capital. Project 2 would still have a positive (though larger) NPV and still have an IRR > cost of capital. This assumes that the lowering in income tax rate does not change the cost of equity. 3. a. The payback periods (undiscounted) can be found by dividing the annual cash flow into the initial investment for each project. Thus: Project 1: 822,800/200,000 = 4.1 years Project 2: 300,000/85,000 = 3.5 years b. The three weaknesses of payback period are (1) PP ignores cash flow after the calculated payback period. (2) PP does not discount future flows (3) Choice of cut-off (e.g. do project only if PP < 3 years) is arbitrary
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422 Answer: Question 2.22 - Kolobok 1. Target costing is focused on market pricing or the prices of a firm’s most direct competitors. The process for determining product pricing involves the following five steps: (1) determine the market price, (2) determine the desired profit, (3) calculate the target cost at market price less the desired profit, (4) use value engineering to identify ways to reduce product cost, and (5) use continuous improvement and operational controls to further reduce costs and increase profits. 2. The main difference between the two methods of pricing is a different starting point for determining product price. Mark-up pricing is based on existing costs and a desired return. The price is then determined by adding the product cost and the desired mark-up. This method provides little incentive to reduce costs as long as sales are profitable. Using target costing, product prices are determined by reviewing competitive pricing and setting prices according to market strategies and positioning. Target costing moves from the existing market prices to the process of managing the product costs in order to earn a desired return. Target costing motivates process improvements. The process is intended to increase or maintain sales while increasing product profitability by reducing product costs through the elimination of non-value added activities.
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