The internal rate of return for a project can be determined
Answer(s): C
The IRR is a capital budgeting technique that calculates the interest rate that yields a net present value equal to $0. It is the interest rate that will discount the future cash flows to an amount equal to the initial cost of the project. Thus, the higher the PR, the more favorable the ranking of the project.
Carco, Inc. wants to use discounted cash flow techniques when analyzing its capital investment projects. The company is aware of the uncertainly involved in estimating future cash flows. A simple method some companies employ to adjust for the uncertainly inherent in their estimates is to
Uncertainly can be compensated for by adjusting the desired rate of return. If projects have relatively uncertain returns, a higher rate should be required. A lower rate of return may be acceptable given greater certainly. The concept is that with increased risk should come increased rewards1 i.e., a higher rate of return.
The accountant of Ronier, Inc. has prepared an analysis of a proposed capital project using discounted cash flow techniques. One manager has questioned the accuracy of the results because the discount factors employed in the analysis have assumed the cash flows occurred at the end of the year when the cash flows actually occurred uniformly throughout each year. The net present value calculated by the accountant will
Answer(s): D
The effect of assuming cash flows occur at the end of the year simply understates the present values of the future cash flows, in reality, they probably occur on the average at mid-year.
High-Tech Industries is considering the acquisition of a new state-of-the-art manufacturing machine to replace a less efficient machine. Hi-Tech has completed a net present value analysis and found it to be favorable. Which one of the following factors should not be of concern to Hi-Tech in its acquisition considerations?
The investment tax credit is of no concern because it no longer exists. The 1986 Tax Reform Act eliminated the investment tax credit.
The internal rate of return on an investment
Investment projects may be mutually exclusive under conditions of capital rationing (limited capital). In other words, scarcity of resources will prevent an entity from undertaking all available profitable activities. Under the PR method, an interest rate is computed such that the present value of the expected future cash flows equals the cost of the investment (NPV = 0). The IRR method assumes that the cash flows will be reinvested at the IRR. The NPV is the excess of the present value of the estimated net cash inflows over the net cost of the investment. The cost of capital must be specified in the NPV method. An assumption of the NPV method is that cash flows from the investment will be reinvested at the particular project's cost of capital. Because of the difference in the assumptions regarding the reinvestment of cash flows, the two methods will occasionally give different answers regarding the ranking of mutually exclusive projects. Moreover, the IRR method may rank several small, short-lived projects ahead of a large project with a lower rate of return but with a longer life span. However, the large project might return more dollars to the company because of the larger amount invested and the longer time span over which earnings will accrue. When faced with capital rationing, an investor will want to invest in projects that generate the most dollars in relation to the limited resources available and the size and returns from the possible investments. Thus, the NPV method should be used because it determines the aggregate present value for each feasible combination of projects.
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