AFM291 Lecture Notes - Lecture 8: Startup Company, Net Present Value, Opportunity Cost

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blueporpoise731

11 Sep 2017

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM291

Professor

Mindy Wolfe

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Document Summary

Chapter 8: investment decision rules (cid:862)whe(cid:374) (cid:373)aki(cid:374)g a(cid:374) i(cid:374)(cid:448)est(cid:373)e(cid:374)t decisio(cid:374), take the alte(cid:396)(cid:374)ati(cid:448)e (cid:449)ith the highest npv. Choosi(cid:374)g this alte(cid:396)(cid:374)ati(cid:448)e is e(cid:395)ui(cid:448)ale(cid:374)t to (cid:396)ecei(cid:448)i(cid:374)g its npv i(cid:374) cash toda(cid:455). (cid:863) The npv is positive only for discount rates that are less than the internal rate of return (irr). It is the average return for taking on the investment opportunity. Rule: (cid:862)take a(cid:374)(cid:455) i(cid:374)(cid:448)est(cid:373)e(cid:374)t oppo(cid:396)tu(cid:374)it(cid:455) (cid:449)he(cid:396)e the irr e(cid:454)ceeds the oppo(cid:396)tu(cid:374)it(cid:455) cost of capital. Tu(cid:396)(cid:374) do(cid:449)(cid:374) a(cid:374)(cid:455) oppo(cid:396)tu(cid:374)it(cid:455) (cid:449)hose irr is less tha(cid:374) the oppo(cid:396)tu(cid:374)it(cid:455) cost of capital. (cid:863) In general, the irr rule works for a stand-alone project if all of the p(cid:396)oject"s (cid:374)egati(cid:448)e cash flo(cid:449)s precede its positive cash flows. Note: but in other cases the irr rule may disagree with the npv rule and thus be incorrect. Irr will not exist in situations where npv is positive for all values of the discount rate. Thus, in these situations, the irr rule cannot be used.

Related Questions

Which of the following five statements are correct?

The effective annual rate (EAR) for a loan with a stated APR of 8% compounded monthly is about 8.3%.

Fundamentally, interest rates are determined by the Federal Reserve (central bank).

The rate of growth of your purchasing power is determined by the nominal interest rate.

Real interest rates indicate the rate at which your money will grow if invested for a certain period.

The investor's opportunity cost of capital is the best available expected return offered in the market on an investment of comparable risk and term of the cash flows being discounted.

Which of the following five statements are correct?

When the risks of two projects are different, only the NPV rule will give a reliable answer.

When the risks of two projects are different, only the IRR rule will give a reliable answer.

The IRR investment rule states you should turn down any investment opportunity where the IRR is less than the opportunity cost of capital.

The profitability index can can be easily adapted for determining the correct investment decisions when multiple resource constraints exist.

You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is the profitability index.

Fill in the blank with the appropriate terms:

The IRR is that rate of return (or discount rate) which equals the (A)_____ of the future (B)_________ for an investment with its (C)_______. The IRR is the rat eof return which equales the NPV of an investment to (D)_______. An investment is (E) ________ if the IRR exceeds the rate of return that could be earned in the financial markets on investment of equal riskl an investment project is (F)_________ if the IRR is less than the relevant rate of return in the financial markets.

A (G)________ is the impact that a given capital budgeting project might have on cash flows in another areaof the firm. These changes in cash flos (H) (are/are not) incrementalcash flows for the project under construction.

ultramarinefly639

Jack Smith reportedly was paid $10.1 million to write his book The Fork in the RoadThe Fork in the Road. The book took three years to write. In the time he spentâ writing, Jack Smith could have been paid to make speeches. Given hisâ popularity, assume that he could earn $8.2 million a yearâ (paid at the end of theâ year) speaking instead of writing. If his cost of capital is 10% perâ year, then the NPV of agreeing to write the bookâ (ignoring any royaltyâ payments) is -$10,292,186.

How many IRRs are there in thisâ problem? Does the IRR rule give the right answer in thisâ case? (Note: Consider the upfront payment as a positive cash flow and the opportunity cost of missed speaking fees as negative cashâ flows.)

The IRR is _____ â(Round to two decimalâ places.)

How many IRRs are there in thisâ problem? â(Select the best choiceâ below.)

One IRR

Three IRRs

Two IRRs

Four IRRs

Does the IRR rule give the right answer in thisâ case?âââ(Select the best choiceâ below.)

âYes, because the IRRâ (62.14%â) is greater than the cost of capital.

âYes, because the NPV is positive.

âNo, because the IRR is negative.

âNo, because the NPV is negative â(â$10,292,186â), and therefore the IRR gives the wrong answer.

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AFM291 Lecture Notes - Lecture 8: Startup Company, Net Present Value, Opportunity Cost

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