ANSWER: The project with the cash flows that come in earlier may be better because of the uncertainty of the future. The large flows predicted far out in time are less likely to come true than
2 modest flows predicted in the short run. In fact, this is a major business problem. People tend to predict marvelous results in the distant future that are often very unrealistic. (We'll have a great deal to say about this in later chapters.) 7. Suppose the present value of cash ins and outs is very close to balanced for a project to build a new $50M factory, so that the NPV is +$25,000. The same company is thinking about buying a new trailer truck for $150,000. The NPV of projected cash flows associated with the truck is also about $25,000. Does this mean that the two projects are comparable? Is one more desirable than the other? How are their IRRs likely to compare? If the cash flows have similar risks are the projects equally risky? ( Hint : Think in terms of the size of the investment placed at risk relative to the financial rewards expected.) ANSWER: Projects of grossly different sizes are not readily comparable. In this case, the factory project is marginal, because its NPV is minimally positive relative to the size of the investment required to undertake it. Conversely, the truck is a pretty good deal because its NPV is substantial relative to the investment required to get it. The factory's IRR would be just a hair above the cost of capital while the truck's IRR would exceed k by quite a bit. The factory is really a risky project because a small unfavorable percentage variation in the cash flows planned could result in a big dollar loss relative to the capital budgeting analysis. 8. Think about the cash flows associated with putting $100,000 in the bank for five years, assuming you draw out the interest each year and then close the account. Now think about a set of hypothetical cash flows associated with putting the same money in a business, operating for five years, and then selling out. Write an explanation of why the IRR on the business project is like the bank's interest rate. How are the investments different? rate does exactly the same thing. If we take the present value of the interest payments and the final withdrawal at the bank's interest rate, we'll get the amount of the initial deposit. (This is also exactly like a bond's yield.) There are two major differences between the bank account and the business. The bank account's periodic cash flows will be constant while the business's are likely to vary. Further, all of the bank's flows are nearly certain while the business's are subject to considerable risk.