NPV Profiles Timing Differences

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University of Wisconsin, –Parkside *

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732

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Finance

Date

Jan 9, 2024

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docx

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2

Uploaded by agerstein01

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a. Using a financial calculator, calculate NPVs for each plan (as shown in the table below) and graph each plan's NPV profile. Discount Rate NPV Plan A, $ million NPV Plan B, $ million 0% 2.56 32.69 5 1.83 15.54 10 1.16 6.56 12 0.91 4.19 15 0.56 1.44 17 0.33 0.00 20 0.00 -1.72 b. c. The crossover rate is approximately 16.41%. If the cost of capital is less than the crossover rate, then Plan B should be accepted; if the cost of capital is greater than the crossover rate, then Plan A is preferred. At the crossover rate, the two projects' NPVs are equal. d. Yes. Assuming (1) equal risk among projects, and (2) that the cost of capital is a constant and does not vary with the amount of capital raised, the firm would take on all available projects with returns greater than its 11.3% WACC. If the firm had invested in all available projects with returns greater than 11.3%, then its best alternative would be to repay capital. Thus, the WACC is the correct reinvestment rate for evaluating a project's cash flows. Correct Response eBook An oil-drilling company must choose between two mutually exclusive extraction projects, and each requires an initial outlay at t = 0 of $12.8 million. Under Plan A, all the oil would be extracted in 1 year, producing a cash flow at t = 1 of $15.36 million. Under Plan B, cash flows would be $2.2744 million per year for 20 years. The firm's WACC is 11.3%. a. Construct NPV profiles for Plans A and B. Enter your answers in millions. For example, an answer of $10,550,000 should be entered as 10.55. If an amount is zero, enter "0". Negative
values, if any, should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to two decimal places. Discount Rate NPV Plan A NPV Plan B 0% $ 2.56 million $ 32.69 million 5 1.83 million 15.54 million 10 1.16 million 6.56 million 12 0.91 million 4.19 million 15 0.56 million 1.44 million 17 0.33 million 0.00 million 20 0.00 million -1.72 million Identify each project's IRR. Do not round intermediate calculations. Round your answers to two decimal places. Project A: 20 % Project B: 17 % Find the crossover rate. Do not round intermediate calculations. Round your answer to two decimal places. %16.41 b. Is it logical to assume that the firm would take on all available independent, average-risk projects with returns greater than 11.3%? Yes If all available projects with returns greater than 11.3% have been undertaken, does this mean that cash flows from past investments have an opportunity cost of only 11.3%, because all the company can do with these cash flows is to replace money that has a cost of 11.3%? Yes Does this imply that the WACC is the correct reinvestment rate assumption for a project's cash flows? Yes
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