finance data bank
6-21. You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its revenues will grow at 2% per year for every year after that.
a. Which investment has the higher IRR?
b. Which investment has the higher NPV when the cost of capital is 7%?
c. In this case, for what values of the cost of capital does picking the higher IRR give the correct answer as to which investment is the best opportunity?
6-22. You have just started your summer internship, and your boss asks you to review a recent analysis that was done to compare three alternative proposals to enhance the firm’s manufacturing facility. You find that the prior analysis ranked the proposals according to their IRR, and recommended the highest IRR option, Proposal A. You are concerned and decide to redo the analysis using NPV to determine whether this recommendation was appropriate. But while you are confident the IRRs were computed correctly, it seems that some of the underlying data regarding the cash flows that were estimated for each proposal was not included in the report. For Proposal B, you cannot find information regarding the total initial investment that was required in year 0. And for Proposal C, you cannot find the data regarding additional salvage value that will be recovered in year 3. Here is the information you have:
Suppose the appropriate cost of capital for each alternative is 10%. Using this information, determine the NPV of each project. Which project should the firm choose?
Why is ranking the projects by their IRR not valid in this situation?
6-23. Use the incremental IRR rule to correctly choose between the investments in Problem 21 when the cost of capital is 7%. At what cost of capital would your decision change?
6-24. You work for an outdoor play structure manufacturing company and are trying to decide between two projects:
Use the incremental IRR to determine the range of discount rates for which each project is optimal to undertake. Note that you should also include the range in which it does not make sense to take either project.
6-26. Consider two investment projects, which both require an upfront investment of $10 million, and both of which pay a constant positive amount each year for the next 10 years. Under what conditions can you rank these projects by comparing their IRRs?
6-27. You are considering a safe investment opportunity that requires a $1000 investment today, and will pay $500 two years from now and another $750 five years from now.
a. What is the IRR of this investment?
b. If you are choosing between this investment and putting your money in a safe bank account that pays an EAR of 5% per year for any horizon, can you make the decision by simply comparing this EAR with the IRR of the investment? Explain.
6-28. AOL is considering two proposals to overhaul its network infrastructure. They have received two bids. The first bid, from Huawei, will require a $20 million upfront investment and will generate $20 million in savings for AOL each year for the next three years. The second bid, from Cisco, requires a $100 million upfront investment and will generate $60 million in savings each year for the next three years.
a. What is the IRR for AOL associated with each bid?
b. If the cost of capital for this investment is 12%, what is the NPV for AOL of each bid? Suppose Cisco modifies its bid by offering a lease contract instead. Under the terms of the lease, AOL will pay $20 million upfront, and $35 million per year for the next three years. AOL’s savings will be the same as with Cisco’s original bid.
c. Including its savings, what are AOL’s net cash flows under the lease contract? What is the IRR of the Cisco bid now?
d. Is this new bid a better deal for AOL than Cisco’s original bid? Explain.
6-29. Natasha’s Flowers, a local florist, purchases fresh flowers each day at the local flower market. The buyer has a budget of $1000 per day to spend. Different flowers have different profit margins, and also a maximum amount the shop can sell. Based on past experience, the shop has estimated the following NPV of purchasing each type:
What combination of flowers should the shop purchase each day?
6-30. You own a car dealership and are trying to decide how to configure the showroom floor. The floor has 2000 square feet of usable space.You have hired an analyst and asked her to estimate the NPV of putting a particular model on the floor and how much space each model requires:
In addition, the showroom also requires office space. The analyst has estimated that office space generates an NPV of $14 per square foot. What models should be displayed on the floor and how
6-31. Kaimalino Properties (KP) is evaluating six real estate investments. Management plans to buy the properties today and sell them five years from today. The following table summarizes the initial cost and the expected sale price for each property, as well as the appropriate discount rate based on the risk of each venture.
KP has a total capital budget of $18,000,000 to invest in properties.
a. What is the IRR of each investment?
b. What is the NPV of each investment?
c. Given its budget of $18,000,000, which properties should KP choose?
d. Explain why the profitably index method could not be used if KP’s budget were $12,000,000 instead. Which properties should KP choose in this case?
6-32. Orchid Biotech Company is evaluating several development projects for experimental drugs. Although the cash flows are difficult to forecast, the company has come up with the following estimates of the initial capital requirements and NPVs for the projects. Given a wide variety of staffing needs, the company has also estimated the number of research scientists required for each development project (all cost values are given in millions of dollars).
a. Suppose that Orchid has a total capital budget of $60 million. How should it prioritize these projects?
b. Suppose in addition that Orchid currently has only 12 research scientists and does not anticipate being able to hire any more in the near future. How should Orchid prioritize these projects?
c. If instead, Orchid had 15 research scientists available, explain why the profitability index ranking cannot be used to prioritize projects. Which projects should it choose now?