bus224 tut 3
Q1. Peirson: Chapter 5: Questions 2, 3, 4, 5, 6, 10 and 11.
Chapter 5
2. What factors does the required rate of return of a project reflect?
Soln: The required rate of a return for a project reflects the rate of return that could be generated by investing in the next best alternative investment. This discount rate reflects the return required by the firm as compensation for having funds tied up in the project. The compensation demanded increases as the uncertainty, or risk, associated with the project’s expected cash-flows increases. The firm will also require more from a project as expected inflation increases as additional compensation for the loss in the purchasing power of the funds invested in the project. Even in the absence of either risk or inflation, the firm will still demand compensation from the project, as it has incurred an opportunity cost in investing in this project as opposed to investing in an income-generating risk-free asset such as a government-issued debt security
3. Compare the internal rate of return and net present value methods of project evaluation. Do these methods always lead to comparable recommendations? If not, why not?
Soln: The net present value of a project is found by discounting the expected future net cash flows at the required rate of return and deducting, from the resulting present value, the project’s initial cash outlay. If the project has a positive net present value, it is acceptable.
The internal rate of return of a project is the rate of return that results in a zero net present value.
When cash flows are conventional, if projects are independent, the decision involves either accepting or rejecting them. In this case, and assuming that there is only one internal rate of return, the two methods lead to the same accept/reject decisions. If the projects are mutually exclusive, it is possible that the two methods will rank projects in a different order. IRR can be less reliable and harder to
Chapter 5
2. What factors does the required rate of return of a project reflect?
Soln: The required rate of a return for a project reflects the rate of return that could be generated by investing in the next best alternative investment. This discount rate reflects the return required by the firm as compensation for having funds tied up in the project. The compensation demanded increases as the uncertainty, or risk, associated with the project’s expected cash-flows increases. The firm will also require more from a project as expected inflation increases as additional compensation for the loss in the purchasing power of the funds invested in the project. Even in the absence of either risk or inflation, the firm will still demand compensation from the project, as it has incurred an opportunity cost in investing in this project as opposed to investing in an income-generating risk-free asset such as a government-issued debt security
3. Compare the internal rate of return and net present value methods of project evaluation. Do these methods always lead to comparable recommendations? If not, why not?
Soln: The net present value of a project is found by discounting the expected future net cash flows at the required rate of return and deducting, from the resulting present value, the project’s initial cash outlay. If the project has a positive net present value, it is acceptable.
The internal rate of return of a project is the rate of return that results in a zero net present value.
When cash flows are conventional, if projects are independent, the decision involves either accepting or rejecting them. In this case, and assuming that there is only one internal rate of return, the two methods lead to the same accept/reject decisions. If the projects are mutually exclusive, it is possible that the two methods will rank projects in a different order. IRR can be less reliable and harder to