Corporate Finance - Corporate Finance Section 2

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1. Two mutually exclusive projects have conventional cash flows, but one project has a larger NPV while the other has a higher IRR. Which of the following most likely explains this conflict?

  • Option : C
  • Explanation : Conflicts between the NPV decision and IRR are due to the scale/size of the project or the different cash flows pattern. Since the size is the same the difference in cash flows will cause the conflict.
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2. Claude Browning is reviewing a profitable investment project that has a conventional cash flow pattern. If the cash flows of the project, initial outlay, and future after-tax cash flows all reduce by half, Browning would predict that the IRR would:

  • Option : A
  • Explanation : The IRR would stay the same because both the initial outlay and the after-tax cash flows halve, so that the return on each dollar invested remains the same. All of the cash flows and their present values also reduce in half. The difference between the total present value of the future cash flows and the initial outlay (the NPV) also halves.
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3. Erika Schneider has evaluated an investment proposal and found that its payback period is two years, it has a negative NPV, and a positive IRR. Is this combination of results possible?

  • Option : C
  • Explanation : If the cumulative cash flows in the first two years equal the outlay and additional cash flows are not very large, this scenario is possible. For example, assume the outlay is 100, the cash flow in Year 1 and 2 is 50 each and the cash flow in Year 3 is 3. The required return is 10 percent. This project would have a payback of 2.0 years, an NPV of -10.97, and an IRR of 1.94 percent.
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4. Capital budgeting projects A and B have similar outlays, but different patterns of future cash flows. The required rate of return for both projects is 12 percent, at which the NPV and IRR turn out to be as follows:

 Cash Flows  
Year    0 123 4NPVIRR(%)
Project A     -5000011017.7721.79
Project B    -5022 22222215.0227.18

  • Option : C
  • Explanation : For these projects, a discount rate of 15.09 percent would yield the same NPV for both (an NPV of 11.03). The cross over point needs to be before the lower IRR (21.79).
    Note: The discount rate (crossover point) at which both the projects have the same NPV is the IRR for the differences in cash flows of the projects. For instance, in this case, it is CF0 = 0, CF1 = -22, CF2 = -22, CF3 = -22, CF4 = 88, CPT IRR. IRR = 15.09%.
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