Question

You are a consultant to a firm evaluating an expansion of its current business. The cash-flow forecasts (in millions of dollars) for the project are as follows:

Years	Cash Flow
0	–	100
1 - 10	+	15

On the basis of the behavior of the firm’s stock, you believe that the beta of the firm is 1.49. Assume that the rate of return available on risk-free investments is 4% and that the expected rate of return on the market portfolio is 13%.

a. What is the project IRR? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

b. What is the cost of capital for the project? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

c. Does the accept-reject decision using IRR agree with the decision using NPV?

• Yes

• No

Answer 1

A. In excel if we enter the given cash flows (year 0 cash flow is negative, other 10 cash flows are positive) and use the function =irr(range of columns containing all 11 cashflows) then we get irr = 8.14%

Remember irr is that rate which makes npv= 0.

B. According to CAPM, cost of capital =

Rf+beta*(Rm-Rf)

= 4 + 1.49*(13-4) = 17.41%

C. For npv calculation we van ise npv function of excel. =Npv(.1741,range of columns containing 10 cashflows of 15 each) + year 0 cash flow

The npv function's output is 68.85 which is present value of future 10 cash flows. To this we add year 0 cashflow to get npv.

68.85-100 = -31.15 is our npv

As npv is negative, we will not select the project. Also as irr is less than required return,(17.41>8.14 )we will not select the project. Thus, the answer is 'yes'. Both methods give answer to reject the project.