Financial management Case study

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9-18: Dimond Hill Jewelers considering the following independent Project:

Expected Net Cashflows

Year Project D

Project Q

0

($2,500)

($2,500)

1

$2,000

$0

2

$900

$1,800

3

$100

$1,000

4

$100

$900

 

Q. Which project(s) should be accepted if the required rate of return for the Project is 10 percent? Compute the NPV and the IRR for both projects.

Solution

NPV Calculation for the project:

Derek’s Donuts is considering

IRR calculation:

The following table represents different NPV at a different discount rate for both projects.

NPV

RRR Project D Project Q
10% $205.42 $253.63
12% $137.92 $218.70
14% $73.61 $92.89
16% $12.28 ($24.59)
17% ($17.33) ($80.42)

 

Derek’s Donuts is considering

Decision:

If we are able to assume that projects D and Q are independent and the budget of the firm is high enough, then we can conclude that the firm will accept both projects Q and D simultaneously based on their positive NPVs.

 

9-20: Derek’s Donuts is considering two mutually exclusive investments. The projects’ expected net cash flows are as follows:

 

Expected net cash flows

Time Project A Project B
0 ($300) ($405)
1 ($387) $134
2 ($193) $134
3 ($100) $134
4 $500 $134
5 $500 $134
6 $850 $134
7 ($100) $0

 

(a) NPV Profile for Project A and B:

Before we graph the NPV Profile for the projects, we must create a data table of projects NPV relative to different discount rates.

RRR

NPV (Project A)

NPV(Project B)

0% $970 $399.00
2% $797.47 $345.59
4% $646.67 $297.45
6% $514.57 $253.92
8% $398.62 $214.47
10% $296.63 $178.60
12% $206.77 $145.93
14% $127.46 $116.08
16% $57.34 $88.75

 

(a) NPV Profile for Project A and B:

Before we graph the NPV Profile for the projects, we must create a data table of projects NPV relative to different discount rates.

RRR NPV (Project A) NPV(Project B)
0% $970 $399.00
2% $797.47 $345.59
4% $646.67 $297.45
6% $514.57 $253.92
8% $398.62 $214.47
10% $296.63 $178.60
12% $206.77 $145.93
14% $127.46 $116.08
16% $57.34 $88.75
18% $-4.73 $63.68
20% $-59.76 $40.62
22% $-108.61 $19.37
24% $-152.02 $-0.26
26% $-190.63 $-18.41
28% $-225.01 $-35.24
30% $-255.65 $-50.87

Based on the above date the following NPV Profile can be drawn:

Derek’s Donuts is considering

NPV Profile

b) What is each project’s IRR?

IRR 2

So, Project B’s Internal Rate of Return (IRR) is higher than the IRR of Project A.

 

C) If you were told that each project’s required rate of return was 12 percent, which project should be selected? If the required rate of return was 15 percent, what would be the proper choice?

 

When each project’s required rate of return was 12 percent:

So, NPV (Project A)= $206.77

So, NPV (Project B)= $145.93

If each project’s required rate of return was 15 percent:

NPV (Project A)= $16.14

NPV (Project B)= $102.12

So, at a cost of capital of 12%, Project A should be selected.  However, if the cost of capital rises to 15%, then the choice is reversed, and Project B should be accepted.

 

D. Looking at the NPV profiles constructed in part a, what is the approximate crossover rate, and what is its significance?

Time Cash Flow Differential
0 $105
1 ($521)
2 ($327)
3 ($234)
4 $366
5 $366
6 $716
7 $100
Cross Over Rate =14.50%

 

Therefore, Cross Over Rate= 14.5%

The crossover rate represents the cost of capital at which the two projects have the same net present value (NPV).  In this scenario, that common net present value, at a cost of capital of 14.50% is $109

Related Article: How RRR and IRR helps to select a project

Derek’s Donuts is considering

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