Question

Question 4 (25 marks/Investment Decision Rules)

Suppose your firm would like to earn 10% yearly return from the following two investment projects of equal risk.

                              

Year (t)	Cash flows from Project A (Ct)	Cash flows from Project B (Ct)
0	–$8,000	–$8,000
1	$2,000	$4,000
2	$3,000	$2,000
3	$5,000	$2,500
4	$1,000	$2,000

(a)       If only one project can be accepted, based on the NPV method which one should it be? Support your answer with calculations.                                                          

(b)       Suppose there is another four-year project (Project C) and its cash flows are as follows:

              

C₀ = –$8,000

             C₁ =   $2,000

               C₂ =   $2,500

               C₃ =   $2,000

               C₄ =   $4,000

(i)     Given the above cash flow patterns, at what required rate of return will Project C have the same NPV as Project B? Briefly explain your answer.                          

(ii)    If Project C has the same risk as Project B, without calculations, explain which project will you pick?                                                                                          

(iii)   If cash flow C₄ of Project C is unknown to you (while C₀ – C₃ are known and as above) and the project’s cost of capital is 10%, what amount of C₄ will make Project C worth accepting?                                                                                        

(iv)   If your firm’s investment policy (based on payback method) is such that it only accepts projects whose initial investment can be recouped within three years, will Project B and/or Project C be accepted?

(c)Based on the estimated cash flows of Project A, will you expect its internal rate of return (IRR) to be positive? Briefly explain your answer WITHOUT calculations. (4marks)

(d) What kind of rate of return is the 10% interest stated in the question for Projects A and B? How can it be used in making investment decisions (i.e. its role in investment decision making)?  

Answer 1

Solutions:

a. Based on the NPV method, we need to calculate the NPV of both the projects and then see which which project gives the highest NPV and that project would be the best investment for the company. The calculations are shown in the excel picture below. Based on the calculations project A has highest NPV and hence the company should go with it.

B. i. Since here we need to find the rate of return for Project C that matches the NPV of Project B, we use goal seek function in excel and get the answer. The explanation is present in the picture below

B. ii. If both Project B and C has the same risks, then we need to choose the project which has the highest NPV among the projects. Since NPV returns the highest dollar figure among the projects, we choose the project which returns the highest

B. iii. If project C is evaluated individually, then the only condition that exists for project C to be accepted is the NPV of project C should be greater than 0. So in the calculations below we shown what amount of C4, will make NPV of Project C positive.

B. iv. If payback period of 3 years is the criteria the we need to see how much of the cash flows are the projects generating in the first 3 years and whether they are able to recover the complete initial investment.

If we see Project B, we are able to generate, $ 8,500 cash flows in first 3 years, which is able to recover the complete initial investment of $ 8,000. Hence Project B is accepted.

But If we see Project C, we are able to generate only $ 6,500 cash flows in first 3 years, which is not able to recover the complete initial investment of $ 8,000. Hence Project C is not accepted based on Payback period of 3 years.

C. Yes, the IRR for Project A, will be positive even without calculations. IRR is the rate which makes the NPV of the project equal to zero. Hence even if we randomly assume a minumum IRR of 1%, the NPV of it is way higher at roughly around more than $ 2,500. Hence for the NPV to become zero, the only way is for the IRR to go up beyond 1%.

D. The 10% rate of return mentioned in the question is the minimum return that the company is expecting to make out of its investments. This is known as the Hurdle Rate. The hurdle rate shows the appropriate compensation that the company will expect based on the risk that it is taking. If an investment is returning less than the hurdle rate, then it does not make sense for the company to invest in it, as their investors are expecting the company to earn higher returns for their investmnet in the company.