1.You are considering making a movie. The movie is expected to cost $10 million upfront and take a year to make. After that, it is expected to make $5 million when it is released in one year and $2 million per year for the following four years. What is the payback period of this investment? If you require a payback period of two years, will you make the movie? Does the movie have positive NPV if the cost of capital is 10%?
2.You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its revenues will grow at 2% per year for every year after that.
a. Which investment has the higher IRR?
b. Which investment has the higher NPV when the cost of capital is 7%?
c. In this case, for what values of the cost of capital does picking the higher IRR give the correct answer as to which investment is the best opportunity?
3.Use the incremental IRR rule to correctly choose between the investments in Problem 2 when the cost of capital is 7%. At what cost of capital would your decision change?