Question

Be very detailed. Show formulas that is used for your conclusions.

Give more than one examples. Show working step by step.

Explanation must excess 150 words.

Part A:

You have calculated the NPV and IRR for two investment projects based on the costs and cash flows, but you can only select the best one to choose between project A, and Project B. Based on the following data, which one will you select, and why?

Project A                     Project B

NPV: $10,000 $9,000

IRR: 9 % 12%

PART B:

If you invested in every stock listed on the New York Stock Exchange, would you be fully diversified? Would you have eliminated all the risks? Explain.

You must provide any in-text citations as per the APA guide. Failure to comply with the APA standard will cause a reduction in your grade.

Answer 1

PART A SOLUTION:

Comparison of Net Present Value and Internal Rate of Return Methods

Similarity

1. Both the net present value and the internal rate of return methods are discounted

cash flow methods which mean that they consider the time value of money.

2. Both these techniques consider all cash flows over the expected useful life of the

investment.

Different conclusion in the following scenarios:

There are circumstances/scenarios under which the net present value method and the

internal rate of return methods will reach different conclusions.

Scenario 1 –Scale or Size Disparity

Being IRR a relative measure and NPV an absolute measure in case of disparity in scale

or size both may give contradicting ranking.

Scenario 2 – Time Disparity in Cash Flows

It might be possible that overall cash flows may be more or less same in the projects

but there may be disparity in their flows i.e. larger part of cash inflows may be occurred

in the beginning or end of the project. In such situation there may be difference in the

ranking of projects as per two methods.

Scenario 3 – Disparity in life of Proposals (Unequal Lives)

Conflict in ranking may also arise if we are comparing two projects (especially mutually

exclusive) having unequal lives.

CONCLUSION:

In conclusion, NPV is a better method for evaluating mutually exclusive projects than the IRR method.   The NPV method employs more realistic reinvestment rate assumptions, is a better indicator of profitability and shareholder wealth. NPV mathematically will give the correct accept-or-reject decision regardless of:

whether the project experiences non-normal cash flows or if differences in project size or timing of cash flows exist.

in our case

Project A                     Project B

NPV: $10,000 $9,000

IRR: 9 % 12%

Please Choose Project A over Project B as it has the highest NPV.

PART B SOLUTION:

To understand this question, we need to understand the types of Risk:

Total Risk = Systematic Risk + Unsystematic Risk.

1. Systematic Risk:

It is the risk due to macro-economic factors. It is the total market risk. It is diversifiable. It is a risk due to the Economy i.e. Markets Risk to Individual Companies.

2. Unsystematic Risk:

It is the risk due to microeconomic factors. It is an Individual Business risk. It is Undiversifiable. It contains Financial and Business Risk.

As Per Capital Market Theory (CMT) and Modern Portfolio Theory(MPT):

we need to Invest in as many stocks as we can to Kill the Systematic Risk.

CMT crux is that we need to Invest in Market Portfolio (all stocks of NYSE) to attain the highest Sharpe Ratio (i.e. the best Risk and Return Tradeoff)

Both this theory strongly suggest that Systematic Risk can be eliminated (and brought to minimum) via Diversification BUT Unsystematic Risk cannot be Eliminated.

So even if we Invest In all stocks of NYSE there will be Total Risk due to Unsystematic Risk not being eliminated.

(SELF NOTE: DO NOT FORM PART OF THE ANSWER

The above answer is given from Portfolio Managers Point of View who Invest in Market.

BUT

From An Individual Business Point of View:

Systematic Risk cannot be Eliminated as Macro Economic Factors are not in its Hands to control.

Unsystematic Risk can be Eliminated as Micro Economic Factors like Finance Risk, is in its Hands to control.)

Thank you, Hope you find the answer helpful.