# C when contradictory signals are provided by the npv

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( c ) When contradictory signals are provided by the NPV and the IRR methods, the former should be used because the firm cannot assume that it can reinvest the net cash flows from the project at the same higher IRR earned on the project. b. Problems: 8. ( a ) The NPV of each project is obtained by subtracting from the present value of the net cash flows ( PVNCF ) for each project the initial cost of the investment ( C 0). Thus, NPV = \$600,000 for project A, \$450,000 for project B, and \$300,000 for project C. With capital rationing, the firm can undertake either project A only or projects B and C. Ranking projects according to their NPV , the firm would undertake projects B and C with total NPV of \$750,000 ( b ) Since the firm faces capital rationing, however, it should use the profitability index ( PI ) as its investment criterion. The PI of each project is given by the ratio of the PVNCF to the C 0 of each project For project A, PI = \$3,000,000/\$2,400,000 = 1.25. For project B, PI = \$1,750,000/\$1,300,000 = 1.35. For project C, PI = \$1,400,000/\$1,100,000 = 1.27. Using the PI investment criterion indicates that the firm should undertake projects B and C. The reason for this is that projects B and C provide a higher rate of return per dollar invested than project A. Note that the sum of the NPV of projects B and C exceeds the NPV for project A. 10. The cost of equity capital for this firm ( ke ) can be calculated with the dividend valuation model, as follows ke = ( D/P) + g where D is the amount of the yearly dividend paid per share of the common stock of the firm, P is the price of a share of the common stock of the firm, and g is the expected annual growth rate of dividend payments. Since the company pays half of its expected \$200 million in net after-tax earnings in dividends and there are 100 million shares of common stock of the firm, the dividend per share is \$1. With a share of the common stock of the firm selling for eight times current earnings, the price of a share of the common stock of the firm is \$8. With the expected annual growth of earnings and dividends of the firm of 7.5 percent, the cost of equity capital for this firm is ke = (\$1/\$8) + 0.075 = 0.125 + 0.075 = 0.20 or 20%

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Spreadsheet problem 1: The present value of net revenue is \$760. The firm should purchase the machine since the NPV of the project is positive.
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c When contradictory signals are provided by the NPV and...

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