) When contradictory signals are provided by the
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
earned on the project.
of each project is obtained by subtracting from the present value of the net
cash flows (
) for each project the initial cost of the investment (
= $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
, the firm would undertake projects B and C with
total NPV of $750,000
) Since the firm faces capital rationing, however, it should use the profitability index
) as its investment criterion. The
of each project is given by the ratio of the
0 of each project
For project A,
= $3,000,000/$2,400,000 = 1.25.
For project B,
= $1,750,000/$1,300,000 = 1.35.
For project C,
= $1,400,000/$1,100,000 = 1.27.
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
of projects B and C
for project A.
10. The cost of equity capital for this firm (
) can be calculated with the dividend
model, as follows
is the amount of the yearly dividend paid per share of the common stock of the
is the price of a share of the common stock of the firm, and
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
= ($1/$8) + 0.075 = 0.125 + 0.075 = 0.20 or 20%