Part I:
a. Consider the project with the following expected cash flows:
Year Cash Flow
0 - $550,000
1 $90,000
2 $100,000
3 $450,000
- If the discount rate is 0%, what is the project's net present value?
- If the discount rate is 4%, what is the project's net present value?
- If the discount rate is 8%, what is the project's net present value?
- If the discount rate is 10%, what is the project's net present value?
- What is this project's internal rate of return?
Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?
b. Consider a project with the expected cash flows:
Year Cash Flow
0 - $315,000
1 +71,000
2 +150,000
3 +$150,000
- What is this project's internal rate of return?
- If the discount rate is 0%, what is this project's net present value?
- If the discount rate is 4%, what is this project's net present value?
- If the discount rate is 8%, what is this project's net present value?
- If the discount rate is 12%, what is this project's net present value?
Now draw (for yourself) a chart where the discount rate is on the horizontal axis (the "x" axis) and the net present value on the vertical axis (the Y axis). Plot the net present value of the project as a function of the discount rate by dots for the four discount rates. connect the four points using a free hand 'smooth' curve. The curve intersects the horizontal line at a particular discount rate. What is this discount rate at which the graph intersects the horizontal axis?
c. A project requiring a $3.3 million investment has a profitability index of 0.96. What is its net present value? (Remember: Profitability Index is defined as Present Value of the proceeds divided by the initial investment)
Part II:
Which method do you think is the better one for making capital budgeting decisions - IRR or NPV?