Investments A and B are mutually exclusive and cost $2,000 each. The firm's cost of capital is 9%, and the investments' estimated cash inflows are? cash inflow A B year 1 $2,320 ??? 2 ??? ??? 3 ??? $2,810 ? ? a. What investment(s) should the firm make according to net present value? ?b. What investment(s) should the firm make according to internal rate of return? c. If the firm can reinvest
funds earned in year 1 at 10%, which investment(s) should the firm make? ?
What will be an ideal response?
a.?Net present value of A: $2,320/(1 + .09) - 2,000 = $128?Net present value of B: $2,810/(1 + .09)3 - 2,000 = $170Since the investments are mutually exclusive, the firm cannot make both and will select B since it has the higher NPV.??b.Internal rate of return of A: $2,000 = $2,320/(1 + r) PVIF = .862 r = 16%? Internal rate of return of B: $2,000 = $2810/(1 + r)3 PVIF = .712 r = 12%Since the investments are mutually exclusive, the firm cannot make both and will select A since it has the higher IRR.?c.?There is an obvious conflict in the rankings. The purpose of this question is to help reconcile the conflict. If the $2,320 grow annually at 10 percent, then the future value is $2,320(1 + .1)2 = $2,320(1.210) = $2,807.20.Investment B is now clearly preferred to A because the terminal value of S is $2,807.20, which is less than $2810.
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