Chapter 9

Concept Review

6, a, NPV is the present value of the cash flows generated from taking a project. The decision rule is to accept the project with a positive NPV and reject the project with a negative NPV.

b, The NPV method is superior to other methods because it can rank mutually exclusive projects unambiguously and can differentiate projects of different scale and time horizon. A project with NPV of $2500 indicates that shareholder’s wealth would increase by $2500 if the project were implemented.

7, a, IRR is calculated by finding the discount rate that makes the NPV to zero. At the IRR, the net value of the project is considered to be zero. The decision rule for IRR is to accept the project with IRR greater than the discount rate and to reject the project with the IRR less than the discount rate.

b, IRR is the discount rate than cause NPV to be zero. NPV is considered to be better than IRR in any situation, because IRR can lead to misleading results if there are non-conventional cash flows and it also ambiguously ranks some mutually exclusive projects.

c, IRR is frequently used because it is easier for managers to rate performance in relative terms. In a situation where a discount rate is unknown, IRR would be more useful than NPV.

Questions and problems

8, When the required return is 11%, we get NPV=$5991.49 by the financial calculator. In this case, we accept the project because the NPV is positive.

With the required return of 30%, we get the NPV of -$4213.93. In this case we reject the project because the NPV is negative.

9, When the required return is 8%, we get the NPV of $40036.31. At the 8% required return, we accept the project because the NPV is positive.

When the required return is 20%, we get the NPV of -$23117.45. Since the NPV is negative, we reject the project.

We would be indifferent about the project when the NPV is equal to the zero, which is when the discount rate is equal to the IRR....