Question

As chief financial officer, it is your responsibility to weigh financial pros and cons of the many investment opportunities developed by your company's research and development division. You are currently evaluating two competing 15-year projects that differ in several ways. Relative to your firm's current EPS, the first project is expected to generate above-average EPS during the first 5 years, average EPS during the second 5 years,and then below-average EPS in the last 5 years. The second project is expected to generate below-average EPS during the first 5 years, average EPS in the second 5 years, and then well-above-average EPS in the last 5 years. Is the choice obvious if you expect that the second investment will result in a larger overall earnings increase? Given the goal of the firm, what issues will you consider before making a final decision? Is the choice obvious if you expect that the second investment will result in a larger overall earnings increase? (Select the best answer below.)

A. No. The firm cannot earn a return on funds it receives, therefore the receipt of funds, whether sooner or later, will not affect the choice.

B. Yes. The firm can earn a return on funds it receives, therefore the receipt of funds is preferred later rather than sooner. The first project generates a below-average return in the last 5 years, while the second project generates well-above-average returns in the same period.

C. Yes. The firm can earn a return on funds it receives, therefore, the project that earns the larger overall earnings increase is the best choice.

D. No. The firm can earn a return on funds it receives, therefore the receipt of funds is preferred sooner rather than later. The first project generates an above-average return in the first 5 years, while the second project generates below-average returns in the same period.

Answer 1

Solution:

In first project, company is getting above average EPS during first 5 years, average EPS in next 5 years and below avaerage EPS in last 5 years. It means cash flow in first 5 years are greater than cash flows in next 10 years. Therefore if cash flow received in greater value in earlier years is better than cash flow received in greater value in last years because company can earn return on funds it receives in earlier years, therefore it provides a higher future value. If cash flow receive in greater value in last years then company will earn less return on that funds because it will be invested for small duration.

In 2nd project, company is getting below average EPS in first 5 years, average EPS in next 5 years and above average EPS in last 5 years. If second investment will results in a larger overall earnings increase then it cannot be presumed that this investment will be better.

The firm can earn a return on funds it receives, therefore the receipt of funds is preferred sooner rather than later. The first project generates an above-average return in the first 5 years, while the second project generates below-average returns in the same period.

Therefore choice D is correct option.