Explanation : Whenever there is a conflict in ranking between the IRR rule and the NPV rule, the NPV rule should be used to decide between mutually exclusive projects. This is because the NPV represents the expected addition to shareholder wealth from an investment. The maximization of shareholder wealth is a basic financial objective of a company and hence, the NPV rule must be given preference. Project B has the highest NPV among the three projects and thus results in the greatest addition to shareholder wealth. While there is a conflict among the NPV and IRR rules for projects B and C, NPV rule is to be given preference for its superiority over IRR and hence B would be the most appropriate choice. Payback period should be given the least consideration as it does not affect the decision due to its various drawbacks.
Explanation : When the IRR and NPV rules conflict in ranking projects, consider the NPV rule. The NPV of an investment represents the expected addition to shareholder wealth from an investment, and we take the maximization of shareholder wealth to be a basic financial objective of a company.
Explanation : Using a financial calculator, enter the cash flows to compute NPV and IRR.
CF0 = - 3 million, CF1 = 1.2 million, CF2 = 1.05 million, CF3 = 0.9 million,
CF4 = 0.75 million, I= 10%, CPT NPV = 0.147 million, CPT IRR = 12.44%.
Since the NPV is positive and the IRR is greater than the cost of capital,
both rules indicate that the project should be accepted.
Explanation : Holding period return is calculated as follows:
HPR = P1– P0+ D1 / P0 = ending value – beginning value + cash flow
beginning value where:
P0 = initial investment
P1 = price received at the end of the holding period
D1 = cash paid by the investment at the end of the holding period
HPR = (78 –62 + 5) / 62 = 33.87%. The HPR is not annualized for
holding periods shorter than a year.