Question

A corporation’s policy manual states: “Our company’s policy is to use 12%, which is our cost...

A corporation’s policy manual states: “Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment.” What is wrong with this policy? In what types of projects will this company over invest? In what types of projects will it under invest?

Homework Answers

Answer #1

This is wrong since all the projects that the company is going to consider can never have similar risk. The required rate of return is directly proportional to the risk of the project and hence risky project needs higher rate of return. In this case all the projects are being provided with the same rate of return. Therefore, risky projects that ideally should have higher rate of return are providing lower return and vice versa. There is also a possibility that some projects might be non feasible but company invested in them since rate of return used is just 12%. The company will therefore overinvest in the risky projects. For less projects, lower rate of return is imminent. But when compared with 12%, which is as per the company’s policy, the project might not be able to deliver the same. The company will, hence, underinvest in less risky projects.

Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
Use the table for the question(s) below. Complete in Excel Show Work. Consider the following list...
Use the table for the question(s) below. Complete in Excel Show Work. Consider the following list of projects: Project Investment NPV A 135,000 6,000 B 200,000 30,000 C 125,000 20,000 D 150,000 2,000 E 175,000 10,000 F 75,000 10,000 G 80,000 9,000 H 200,000 20,000 I 50,000 4,000 23.a) Assuming that your capital is constrained, which investment tool should you use to determine the correct investment decisions? 23.b) Assuming that your capital is constrained, which project should you invest in...
The large furniture retailer "Sofa So Good" is evaluating two mutually exclusive projects: NPV versus IRR....
The large furniture retailer "Sofa So Good" is evaluating two mutually exclusive projects: NPV versus IRR. Consider the following projects where the firms may only choose one not both: The firm's cost of capital/required return equals 9%. NOTE: The firm's cost of capital K, acts as a hurdle rate, and is based on the costs involved in financing other firm projects. The Cost of capital allows us to decide to accept or reject an investment, using IRR, which additionally allows...
Hatch Corporation’s target capital structure is 52 percent debt, 12 percent common stock, and 36 percent...
Hatch Corporation’s target capital structure is 52 percent debt, 12 percent common stock, and 36 percent preferred stock. Information regarding the company’s cost of capital can be summarized as follows: · The company’s bonds have a nominal yield to maturity of 6.7 percent. · The company’s preferred stock sells for $35 a share and pays an annual dividend of $3 a share. · The company’s common stock sells for $25 a share, and is expected to pay a dividend of...
Consider the following scenario: An engineering firm is considering switching from a manual to an automated...
Consider the following scenario: An engineering firm is considering switching from a manual to an automated machine for quality control. Under the current process: Manual inspection: Works earn $35/ hour, inspect 7 items per hour and need 16 inspectors total, working 8 hours per shift and 200 shifts a year There is a false negative of 15%, so the company actually pays workers $25/hr and sets aside $10/hr to cover cost of poor quality (considered a regular business expense) Proposed...
Problem 12-21 Preference Ranking of Investment Projects [LO12-5] The management of Revco Products is exploring four...
Problem 12-21 Preference Ranking of Investment Projects [LO12-5] The management of Revco Products is exploring four different investment opportunities. Information on the four projects under study follows: Project Number 1 2 3 4 Investment required $ (400,000 ) $ (350,000 ) $ (250,000 ) $ (370,000 ) Present value of cash inflows at a 10% discount rate 447,930 490,619 261,279 410,433 Net present value $ 47,930 $ 140,619 $ 11,279 $ 40,433 Life of the project 6 years 12 years...
NPV and IRR, Mutually Exclusive Projects For discount factors use Exhibit 12B-1 and Exhibit 12B-2. Hunt...
NPV and IRR, Mutually Exclusive Projects For discount factors use Exhibit 12B-1 and Exhibit 12B-2. Hunt Inc. intends to invest in one of two competing types of computer-aided manufacturing equipment: CAM X and CAM Y. Both CAM X and CAM Y models have a project life of 10 years. The purchase price of the CAM X model is $3,600,000, and it has a net annual after-tax cash inflow of $900,000. The CAM Y model is more expensive, selling for $4,200,000,...
Residual Distribution Policy Harris Company must set its investment and dividend policies for the coming year....
Residual Distribution Policy Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose, each of which requires a $6 million investment. These projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and costs of capital are as follows: Project A: Cost of capital = 17%; IRR = 16% Project B: Cost of capital = 12%; IRR = 10% Project C: Cost of...
Problem 14-09 Residual Distribution Policy Harris Company must set its investment and dividend policies for the...
Problem 14-09 Residual Distribution Policy Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose, each of which requires a $5 million investment. These projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and costs of capital are as follows: Project A: Cost of capital = 18%; IRR = 20% Project B: Cost of capital = 12%; IRR = 16% Project C:...
Watson, Inc., is an all-equity firm. The cost of the company’s equity is currently 12 percent,...
Watson, Inc., is an all-equity firm. The cost of the company’s equity is currently 12 percent, and the risk-free rate is 4 percent. The company is currently considering a project that will cost $11.55 million and last six years. The company uses straight-line depreciation. The project will generate revenues minus expenses each year in the amount of $3.25 million. If the company has a tax rate of 35 percent, what is the net present value of the project? (Enter your...
Watson, Inc., is an all-equity firm. The cost of the company’s equity is currently 12 percent,...
Watson, Inc., is an all-equity firm. The cost of the company’s equity is currently 12 percent, and the risk-free rate is 4 percent. The company is currently considering a project that will cost $11.55 million and last six years. The company uses straight-line depreciation. The project will generate revenues minus expenses each year in the amount of $3.25 million. If the company has a tax rate of 35 percent, what is the net present value of the project? (Enter your...