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Consider the project with the following expected cash flows: Year Cash flow 0 $600,000 1 70,000 2 140,000 3 +$600,000 If the discount rate is 0%, what is the project's net present value? If the discount rate is 5%, what is the project's net present value? What is this project's internal rate of return? The internal rate of return of the project is 10%. Net present value at 0% and 5 % are as follows: Year Cash Flow Present value factor at 0% Present Value at 0% 0 -600,000 1 -600,000 1 70,000 1 70,000 2 140,000 1 140,000 3 600,000 1 600,000 Year Cash Flow Present value factor at 5% Present Value at 5% 0 -600,000 0.9523 -571,380 1 70,000 0.9523 66,661 2 140,000 0.9523 133,322 3 600,000 0.9523 571,380 Consider a project with the expected cash flows: Year Cash flow 0 - $48,000 1 + 48,000 2 + 93,000 3 - $93,000. What is this project's internal rate of return? If the discount rate is 5%, what is this project's net present value? Year Cash Flow Present value factor at 5% Present Value at 5% 0 -48,000 0.9523 -45,710 1 48,000 0.9523 45,710 2 93,000 0.9523 88,564 3 -93,000 0.9523 -88,564 The internal rate of return for this project is un-calculate able. Part 2. Read the article linked below. Then write a one to two page paper answering the following question: Which method do you think is the better one for making capital budgeting decisions - IRR or NPV? Defend your answer with references to the background materials. - IRR does not keep track of the sign. This is misdirected. If you borrow money, you will pay the interest, not receive it. Interest rate tables use positive amounts and rates. Interest rate calculation routines use positive principal. We are accustomed to keeping track of borrower and lender outside the actual calculations. - IRR can supposedly give a different decision from NPV on mutually exclusive projects. - More than one IRR is possible with multiple sign changes. Additional IRRs can

occur if the signs of the cash flows change more than once. Not uncommonly, this criticism is combined with Criticism Number One (negative versus positive flows) and presented as the inverted project K. This unnecessarily complicates the picture. - The technique of evaluating differences (also called incremental flows) bypasses the problem with different size projects. It is also a practical way to analyze the difference between alternatives with cash outflows only—a government Economic Analysis (EA) for example. - NPV and IRR can be used together when evaluating different sized projects. If there is an apparent conflict, simply understand what is causing it and present the information differently if necessary. Of course, more realistically comparable investments, such as Projects F and H, IRR and NPV give the same answer regardless. Still, both NPV and IRR give a clearer picture than either alone gives. - Under some circumstances IRR is incalculable. This is perhaps the most serious criticism of IRR. But IRR critics overlook that this is not much of a problem in practice and it applies to NPV as well. The only difference is that it is not as obvious with NPV as it is with IRR. IRR is incalculable in at least five circumstances. First, IRR cannot be calculated if cash flows are all positive. - A second circumstance in which IRR is incalculable is when cash flows are all negative. This, like the all-positive case, needs no further consideration: It is a giveaway and follows the same reasoning as the all-positive case. - A third circumstance in which a positive IRR is incalculable is when net cash flows are zero—say +$1,000 in year 1 and -$1,000 in year 2. - The fourth circumstance under which IRR is incalculable is subtler. It occurs with certain other combinations of cash flows not described above. See Table 10. With a positive cash flow of $0.01 (1 cent), IRR is calculable (IRR is positive but lost in rounding). With a net negative cash flow of 1 cent, NPV diverges from zero and IRR is incalculable. If year 0 and year 1 cash flows are the same, cash flows are zero and IRR incalculable. If we decrease year 1 revenue by 1 cent (-$0.01) to $999.99, NPV is negative at any positive discount rate and IRR is incalculable.

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