Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:

a. If Sharon were risk-indifferent, which investments would she select? Explain why. b. If she were risk-averse, which investments would she select? Why? c. If she were risk-seeking, which investments would she select? Why? d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?

2.

Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating the possible outcomes, the company made the estimates shown in the following table:

| |Expansion A |Expansion B | |Initial investment |$12,000 |$12,000 | |Annual rate of return | | |Pessimistic |16% |10% | |Most likely |20% |20% | |Optimistic |24% |30% |

a. Determine the range of the rates of return for each of the two projects. b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk? d. Assume that...

...yield plus the dividend yield on a security is called the:
A. geometric return.
B. average period return.
C. current yield.
D. total return.
2.
The expected return on a security in the market context is:
A. a negative function of execs security risk.
B. a positive function of the beta.
C. a negative function of the beta.
D. a positive function of the excess security risk.
E. independent of beta.
3.
A capital gain occurs when:
A. the selling price is less than the purchase price.
B. the purchase price is less than the selling price.
C. there is no dividend paid.
D. there is no income component of return.
4.
Which one of the following is a correct statement concerning risk premium?
A. The greater the volatility of returns, the greater the risk premium.
B. The lower the volatility of returns, the greater the risk premium.
C. The lower the average rate of return, the greater the risk premium.
D. The risk premium is not correlated to the average rate of return.
5.
You bought 100 shares of stock at $20 each. At the end of the year, you received a total of $400 in
dividends, and your stock was worth $2,500 total. What was your total return?
A. 45%.
B. 50%.
C. 90%.
D. 20%.
6.
You bought 100 shares of stock at $20 each. At the end of the year, you received a total...

...INTERNALRATE OF RETURN
Many companies wants to have a return on their investment in a few years and begin to evaluate their projects optimistically calculating an internalrate of real return not yielding results in the end. This does not end up being expected by the companies; According to the article the authors John C. Kelleher and Justin J. MacCormack . They suggest that there is a tendency to a risky behavior, Companies started to run the risk of creating unrealistic numbers for themselves and shareholder expectations, which it could confuse communications with investors and inflating managerial rewards.
This confronts us with a real and serious problem when it comes to investing in projects because later we can not generate the expected return and risk of failure in the project, the IRR can generate two different values for the same project when future cash flows switch from negative to positive (or positive to negative). In addition, since the IRR is expressed as a percentage, and This can make small projects appear more attractive than large , although large projects with lower IRR may be more attractive as NPV of smaller projects with IRR .
The management of the IRR must be just when the project generates no interim cash flows - or when those interim cash flows really can be invested in real IRR otherwise would not be realistically analyzing...

...InternalRate of Return
Meaning of Capital Budgeting
Capital budgeting can be defined as the process
of analyzing, evaluating, and deciding whether
resources should be allocated to a project or
not.
Capital budgeting addresses the issue of
strategic long-term investment decisions.
Process of capital budgeting ensure optimal
allocation of resources and helps management
work towards the goal of shareholder wealth
maximization.
Why Capital Budgeting is so Important?
Involve massive investment of resources
Are not easily reversible
Have long-term implications for the firm
Involve uncertainty and risk for the firm
Capital Budget Techniques
Net PresentValue
Discounted
BenefitCost/Profitability
Index Ratio
IRR
Capital Budget
Techniques
Accounting Rate
of Return
Non Discounted
Payback
Period
InternalRate of Return
The rate at which the net present value of cash
flows of a project is zero, I.e., the rate at which
the present value of cash inflows equals initial
investment
Project’s promised rate of return given initial
investment and cash flows.
Consistent with wealth maximization
Accept a project if IRR ≥ Cost of Capital
Question
The management is considering to acquire an
equipment costing $1,00,000 . It is expected...

...000 | |
6 | 500,000 | |
7 | 500,000 | 5,650,000 |
a. Compute the NPV and IRR for the above two projects, assuming a 13% required rate of return.
b. Discuss the ranking conflict.
c. What decision should be made regarding these two projects?
Answer:
a. NPV of A = $211,305 NPV of B = $401,592.64
IRR of A = 16.33% IRR of B = 15.99%
b. The later cash flow of B causes its lower IRR even though it has the higher NPV.
c. B should be accepted because it is the mutually exclusive project with the highest positive NPV.
Keywords: NPV, IRR
AACSB: Analytic skil
4) Tangshan Mining Company must choose its optimal capital structure. Currently, the firm has a 40 percent debt ratio and the firm expects to generate a dividend next year of $4.89 per share and dividends are grow at a constant rate of 5 percent for the foreseeable future. Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 50 percent, it will increase its expected dividend to $5.24 per share. Because of the additional leverage, dividend growth is expected to increase to 6 percent and this growth will be sustained indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 11.34 percent....

...$45M.
• What cash payments will be made by the company at the end of year seven?
As you can see in the graph below, the only cash outflows from the company in year 7 will come from debt financing, with about an $11M outflow from buying back the building from Frank Thomas, as well as about a $6M outflow from paying back the 9% interest loan.
2) At what price must Harmonic repurchase the building from Frank Thomas to produce his required 15% after-tax return?
In order for Frank Thomas to earn his 15% after tax return, Harmonic must buyback the building for just over $11M. The calculations can be seen in the chart below.
3) What proportion of the terminal value must be distributed to Comet Capital to produce its required 25% before-tax rate of return?
In order for Comet Capital to produce its 25% before tax return, they must receive about $73.5M terminal value. This amount is about 69% of the total terminal value at the end of year 7.
4) What are the forecasted cash flows, rates of return on investment, and value created for Burns and Irvine under the debt and equity financing alternatives?
As you can see in the chart below, in respect to equity financing, the forecasted cash flows begin negative, and then gradually increase until a highly increase terminal sell price. The IRR of the investment will be 559%. And the value created from their...

...Accounting rate of return
Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.
Formula
Accounting Rate of Return is calculated using the following formula:
ARR =
Average Accounting Profit
Average Investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.
Decision Rule
Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.
Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project.
Solution
Annual Depreciation = (Initial Investment −...

...Risk and Rates of Return – North Central Utilities
Content
1.) Introduction 3
2.) Question 1 3
3.) Question 2 4
4.) Question 3 4
5.) Question 4 5
6.) Question 5 5
7.) Question 6 6
8.) Question 7 7
9.) Question 8 8
10.) Question 9 9
11.) Question 11 9
12.) List of References 11
13.) Appendix 12
1. Introduction
In 1996, North Central Utilities (hereinafter NCU) is confronted with a tremendous deregulation of its formerly monopolistic market that now becomes more competitive. Suppliers of gas and electricity now have to compete in terms of prices and the shared usage of transmission lines for electricity. Before the deregulation of the market occurred, NCU based its investment decisions neither on net present values (NPV) nor focused on the internalrate of return (IRR). Instead, the managers in charge projected potential future cash flows and adjusted the cost of capital accordingly. This consulting report aims at supporting the NCU managers in making future investment decisions. This is done by providing necessary finance background which the managers lack currently. Specifically, the report proceeds in a chronological way in order to cover the main concerns on the given agenda.
2. Questions
Question 1
a.) If there is a wide spread between high and low returns of a...

...A. net present value.
B. internalrate of return.
C. accounting return.
D. profitability index.
E. payback period.
The internalrate of return is defined as the:
A. maximum rate of return a firm expects to earn on a project.
B. rate of return a project will generate if the project in financed solely with internal funds.
C. discount rate that equates the net cash inflows of a project to zero.
D. discount rate which causes the net present value of a project to equal zero.
E. discount rate that causes the profitability index for a project to equal zero.
Which two methods of project analysis were the most widely used by CEO's as of 1999?
A. net present value and payback
B. internalrate of return and payback
C. net present value and average accounting return
D. internalrate of return and net present value
E. payback and average accounting return
The length of time a firm must wait to recoup, in present value terms, the money it has in invested in a project is referred to as the:
A. net present value period.
B. internalreturn period.
C. payback period.
D. discounted profitability period.
E. discounted...

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