Answer to Question #219759 in Financial Math for Tom

Question

An investment with an initial outlay of R500 000 generates five successive annual cash inflows of R75 000, R190 000, R40 000, R150 000 and R180 000 respectively. The internal rate of return (IRR) is [1] 7,78%. [2] 27,0%. [3] 9,48%. [4] 21,3%. [5] none of the above. Question 2 You must choose between two investments, X and Y . The profitability index (PI), net present value (NPV) and internal rate of return (IRR) of the two investments are as follows: Criteria Investment X Investment Y NPV R44 000 −R22 000 PI 1,945 0,071 IRR 16,00% 8,04% Which investment(s) should you choose, taking all the above criteria into consideration, if the cost of capital is equal to 12% per year? [1] X [2] Y [3] Both X and Y [4] Neither X nor Y [5] Too little information to make a decision 17 DSC1630

Answer 1

Question 1

(5)none of the above.

this is because to find the IRR , you need to work out the NVP FIRST which is impossible since we don't have the percentages.

Question 2

The profitability index is determined by dividing the present value of future cash flows of a project by the initial investment of that project. This helps in determining whether a project would be profitable or not. It provides the managers or the decision-makers with the value created by a project per unit of investment. If the profitability index is more than 1, it means that the project would be profitable for the company.

And, the term net present value refers to the difference between the sum of the present value of future cash flows of a project and its initial investment. If the NPV is positive, it means that the sum of the present value of future cash flows is higher than the initial investment, and thus, the project would be profitable.

And, the internal rate of return (IRR) represents the rate at which the NPV of a project would be zero. Therefore, the higher the IRR, the attractive the project would be. Also, if the IRR of a project is higher than the cost of capital, then the project would be considered as profitable for the company.

It is given that for investment X, the net present value (NPV) is R44,000, the profitability index (PI) is 1.045 and the IRR is 16%. Therefore, investment X would be profitable as it has a positive NPV, a PI of more than 1, and an IRR that is higher than the cost of capital, meaning that the benefits of investment X would outweigh the costs incurred. Thus, investment X should be chosen.

 

Hence, Option [1] is the right choice.

The rationales for the wrong choices are as follows:

Option [2] is incorrect because investment Y has a negative NPV, a profitability index of less than 1, and the IRR is also less than the cost of capital of the company. Meaning that investment Y should be rejected based on all given criteria.

Option [3] is incorrect only investment X is profitable, and investment Y would not be profitable, and therefore, both investment opportunities would not be pursued.

Option [4] is incorrect because investment X is profitable on all the given parameters, and therefore, it would be selected.

Option [5] is incorrect because enough information is provided to make an investment decision.