Chapter 26: Q21RQ (page 1464)
Why are net present value and internal rate of return considered discounted cash flow methods?
NPV and IRR are called the discounted cash flow method as they are based on the time value of money and discount the future cash flow to the present value.
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How is payback calculated with equal net cash inflows?
Refer to Short Exercise S26-4. Continue to assume that the expansion has no residual value. What is the project’s IRR? Is the investment attractive? Why or why not?
Hayes Company is considering two capital investments. Both investments have an initial cost of \(10,000,000 and total net cash inflows of \)17,000,000 over 10 years. Hayes requires a 12% rate of return on this type of investment. Expected net cash inflows are as follows:
Year | Plan Alpha | Plan Beta |
1 | \( 1,700,000 | \) 1,700,000 |
2 | 1,700,000 | 2,300,000 |
3 | 1,700,000 | 2,900,000 |
4 | 1,700,000 | 2,300,000 |
5 | 1,700,000 | 1,700,000 |
6 | 1,700,000 | 1,600,000 |
7 | 1,700,000 | 1,200,000 |
8 | 1,700,000 | 800,000 |
9 | 1,700,000 | 400,000 |
10 | 1,700,000 | 2,100,000 |
Total | \( 17,000,000 | \) 17,000,000 |
Requirements
Use Excel to compute the NPV and IRR of the two plans. Which plan, if any, should the company pursue?
Explain the relationship between NPV and IRR. Based on this relationship and the company’s required rate of return, are your answers as expected in Requirement 1? Why or why not?
After further negotiating, the company can now invest with an initial cost of $9,500,000 for both plans. Recalculate the NPV and IRR. Which plan, if any, should the company pursue?
Water City is considering purchasing a water park in Omaha, Nebraska, for \(1,920,000. The new facility will generate annual net cash inflows of \)472,000 for eight years. Engineers estimate that the facility will remain useful for eight years and have no residual value. The company uses straight-line depreciation, and its stockholders demand an annual return of 12% on investments of this nature.
Requirements
1. Compute the payback, the ARR, the NPV, the IRR, and the profitability index of this investment.
2. Recommend whether the company should invest in this project.
How is the present value of a lump sum determined?
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