Answer the question e and f Your boss, the chief financial officer (CFO) forSouthern Textiles, has just handed you the estimatedcash flows for two proposed projects. Project Linvolves adding a new item to the firm's fabric line. Itwould take some time to build up the market for thisproduct, so the cash inflows would increase over time.Project S involves an add-on to an existing line, andits cash flows would decrease over time. Both projectshave 3-year lives because Southern is planning tointroduce an entirely new fabric at that time.Here are the net cash flow estimates (inthousands of dollars):FlowsYearc. (1)Expected Net CashProject S01Project L$(100) $(100)10 70260503 80 20The CFO also made subjective risk assessments ofeach project, and he concluded that the projects bothhave risk characteristics that are similar to the firm'saverage project. Southern's required rate of return is10%. You must now determine whether one or both ofthe projects should be accepted. Start by answeringthe following questions:a. What is capital budgeting? Are there any similaritiesbetween a firm's capital budgeting decisions andan individual's investment decisions?b. What is the difference between independent andmutually exclusive projects? Between projects withconventional cash flows and projects withunconventional cash flows?What is the payback period? Find thetraditional payback periods for Project L andProject S.(2) What is the rationale for the payback measure?According to the payback criterion, whichproject or projects should be accepted if thefirm's maximum acceptable payback is twoyears and Project L and Project S areindependent? Mutually exclusive?(3) What is the difference between the traditionalpayback and the discounted payback? What iseach project's discounted payback?(4) What are the main disadvantages of thetraditional payback? Is the payback method ofany real usefulness in capital budgetingdecisions?d. (1)Define the term net present value (NPV).What is each project's NPV?(2) What is the rationale behind the NPVmethod? According to NPV, which project orprojects should be accepted if they areindependent? Mutually exclusive? (3)Would the NPVs change if the required rateof return changed?Define the term internal rate of return (IRR).What is each project's IRR?(2) How is the IRR on a project related to theYTM on a bond?e. (1)(3) What is the logic behind the IRR method?According to IRR, which projects should beaccepted if they are independent? Mutuallyexclusive?(4) Would the projects' IRRs change if therequired rate of return changed? Explain.f. (1) Construct the NPV profiles for Project L andProject S. At what discount rate do the profilescross?(2) Look at the NPV profile graph withoutreferring to the actual NPVs and IRRs. Whichproject or projects should be accepted if theyare independent? Mutually exclusive? Explain.Do your answers differ depending on thediscount rate used? Explain.g. (1)What is the underlying cause of rankingconflicts between NPV and IRR?(2) What is the reinvestment rate assumption,and how does it affect the NPV versus IRRconflict?(3) Which capital budgeting method should beused when NPV and IRR give conflictingrankings? Why?h. (1)Define the term modified internal rate ofreturn (MIRR). What is each project's MIRR?(2) What is the rationale behind the MIRRmethod? According to MIRR, which project orprojects should be accepted if they areindependent? Mutually exclusive?(3) Would the MIRRS change if the required rateof return changed?

IRR stands for Internal Rate of Return. It is a capital budgeting method used to evaluate the…

Answered: boss, Southern Textiles, has just…

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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Answer the question e and f

Your boss, the chief financial officer (CFO) for
Southern Textiles, has just handed you the estimated
cash flows for two proposed projects. Project L
involves adding a new item to the firm's fabric line. It
would take some time to build up the market for this
product, so the cash inflows would increase over time.
Project S involves an add-on to an existing line, and
its cash flows would decrease over time. Both projects
have 3-year lives because Southern is planning to
introduce an entirely new fabric at that time.
Here are the net cash flow estimates (in
thousands of dollars):
Flows
Year
c. (1)
Expected Net Cash
Project S
0
1
Project L
$(100) $(100)
10 70
2
60
50
3 80 20
The CFO also made subjective risk assessments of
each project, and he concluded that the projects both
have risk characteristics that are similar to the firm's
average project. Southern's required rate of return is
10%. You must now determine whether one or both of
the projects should be accepted. Start by answering
the following questions:
a. What is capital budgeting? Are there any similarities
between a firm's capital budgeting decisions and
an individual's investment decisions?
b. What is the difference between independent and
mutually exclusive projects? Between projects with
conventional cash flows and projects with
unconventional cash flows?
What is the payback period? Find the
traditional payback periods for Project L and
Project S.
(2) What is the rationale for the payback measure?
According to the payback criterion, which
project or projects should be accepted if the
firm's maximum acceptable payback is two
years and Project L and Project S are
independent? Mutually exclusive?
(3) What is the difference between the traditional
payback and the discounted payback? What is
each project's discounted payback?
(4) What are the main disadvantages of the
traditional payback? Is the payback method of
any real usefulness in capital budgeting
decisions?
d. (1)
Define the term net present value (NPV).
What is each project's NPV?
(2) What is the rationale behind the NPV
method? According to NPV, which project or
projects should be accepted if they are
independent? Mutually exclusive?

Transcribed Image Text:(3) Would the NPVs change if the required rate of return changed? Define the term internal rate of return (IRR). What is each project's IRR? (2) How is the IRR on a project related to the YTM on a bond? e. (1) (3) What is the logic behind the IRR method? According to IRR, which projects should be accepted if they are independent? Mutually exclusive? (4) Would the projects' IRRs change if the required rate of return changed? Explain. f. (1) Construct the NPV profiles for Project L and Project S. At what discount rate do the profiles cross? (2) Look at the NPV profile graph without referring to the actual NPVs and IRRs. Which project or projects should be accepted if they are independent? Mutually exclusive? Explain. Do your answers differ depending on the discount rate used? Explain. g. (1) What is the underlying cause of ranking conflicts between NPV and IRR? (2) What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict? (3) Which capital budgeting method should be used when NPV and IRR give conflicting rankings? Why? h. (1) Define the term modified internal rate of return (MIRR). What is each project's MIRR? (2) What is the rationale behind the MIRR method? According to MIRR, which project or projects should be accepted if they are independent? Mutually exclusive? (3) Would the MIRRS change if the required rate of return changed?

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