A firm’s cost of capital is 12 percent. The firm has three investments to choose among; the cash flows of each are as follows:
Cash Inflows
A B C
Year
1 $395 — $1,241
2 395 — —
3 395 — —
4 — $1,749 —
Each investment requires a $1,000 cash outlay, and investments B and C are mutually exclusive.
a. Which investment(s) should the firm make according to the net present values? Why?
b. Which investment(s) should the firm make according to the internal rates of return? Why?
c. If all funds are reinvested at 15 percent, which investment(s) should the firm make? Would your answer be different if the reinvestment rate were 12 percent?
Problem 2
Management of a firm with a cost of capital of 12 percent is considering a $100,000 investment with annual cash flow of $44,524 for three years.
a. What are the investment’s net present value and internal rate of return?
b. The internal rate of return assumes that each cash flow is reninvested at the internal rate of return. It that investment rate is achieved, what is the total value of the cash flows at the end of the third year?
c. The net present value technique asumes that each cash flow is reinvested at the firm’s cost of capital. What would be the total value of the cash flows at the end of the third year, if the funds are reinvested at the firms’s cost of capital?
Problem 3
A firm has the following investment alternatives. Each one lasts a year.
Investment A B C
Cash inflow $1,150 $560 $600
Cash outflow $1,000 $500 $500
The firm’s cost of capital is 7 percent. A and B are mutually exclusive, and B and C are mutually exclusive.
a. What is the net present value of investment A? Investment B? Investment C?
b. What is the internal rate on investment A? Investment B? Investment
C?
c. Which investment(s) should the firm make? Why?
d. If the firm had unlimited sources of funds, which investment(s) should it make? Why?
e. If there were another alternative, investment D, with an internal rate of return of 6 percent, would that alter your anser to question (d)? Why?
f. If the firm’s cost of capital rose to 10 percent, what effect would that have on investment A’s internal rate of return?
Problem 4
If the cost of capital is 9 percent and an investment costs $56,000, should you make this investment if the estimated cash flows are $5,000 for years 1 through 3, $10,000 for years 4 through 6, and $15,000 for years 7 through 10?
Problem 5
An investment costs $10,000 and offers annual cash inflow of $1,770 for ten years. According to both the net present value and internal rate of return methods of capital budgeting, should the firm make this investment if its cost of capital is (a) 10 percent or (b) 14 percent?
Problem 6
Two mutually exclusive investments cost $10,000 each and have the following cash inflows. The firm’s cost of capital is 12 percent. Investment
Cash inflow:
Year A B
1 $12,407 —
2 — —
3 — —
4 — $19,390
a. What is the net present value of each investment?
b. What is the internal rate of return of each investment?
c. Which investment(s) should the firm make?
d. Would your answers be different to (c) if the funds received in year 1 for investment A could be reinvested at 12 percent? 16 percent? 20 percent?
Problem 7
A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The cost of capital is 6 percent.
Cash Inflow
Year A B
1 $175 $1,100
2 175 —
3 175 —
4 175 —
5 175 —
6 175 —
7 175 —
8 175 —
a. What is the internal rate of return on each investment? Which investment should the firm make?
b. What is the net present value of each investment? Which investment should the firm make?
c. If the cash inflows can be reinvested at 8 percent, which investment should be made?
Problem 8
A firm has the following investment alternatives:
Cash Inflows
Year A B C
1 $400 $— $—
2 400 400 —
3 400 800 —
4 400 800 1,800
Each investment costs $1,400, and the firm’s cost of capital is 10 percent.
a. What is each investment’s internal rate of return?
b. Should the firm make any of these investments?
c. What is each investment’s net present value?
d. Should the firm make any of these investments?
