A firm has the following investment alternatives:? Cash Inflows Year A B C 1 $400 $--- $--- 2 400 400 --- 3 400 800 --- 4 400 800 1,800 ? Each investment costs $1,400 and the firm's cost of capital is 10 percent. ? a. What is each investment's internal rate of return? b. Should the firm make any of these investments? c. ?What is each investment's net present value? d. Should the firm make any of these investments?
What will be an ideal response?
a.Determination of the internal rates of return: Investment A: $400(PVAIF x%, 4y) = $1,400 Interest factor = $1,400/$400 = 3.5 rA = approximately 5.6% (PV = -1400; N = 4; I = ?; PMT = 400, and FV = 0. I = 5.56.)? Investment B: $1,400 = $400/(1 + rB)2 + $800/(1 + rB)3 + $800/(1 + rB)4? Use 12%: $400(.780) + $800(.712) + $800(.634) = $1,389 rB = approximately 12% (11.9%)? Investment C: $1,400 = $1,800/(1 + rC)4 Interest factor = $1,400/$1,800 = .778 rC = approximately 7% (6.5%)?b.The firm should make only investment B.??c.Determination of the net present values:? Investment A: $400(PVAIF 10%, 4y) $1,400 = $400(3.170) ? $1,400 = ($132)? Investment B: $400/(1 + .1)2 + $800/(1 + .1)3 + $800/(1 + .1)4 - 1,400 = $400(.826) + $800(.751) + $800(.683) ? $1,400 = $1,477.60 ? $1,400 = $77.60? Investment C: $1,800/(1 + .1)4 ? $1,400 = $1,800(.683) ? $1,400 = ($170.60)?d.According to the net present value, only investment B should be made. (This confirms the answer to part b.)
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