Question (Total 15 marks)

Net Present Value (NPV) is an indicator of how much value an investment or project adds to the form to help firm in making investment decision. NPV rule is the most accurate and reliable rule, in practice a wide variety of rules we applied. However, Graham and Harvey's study indicates that one-fourth of US.corporations do not using the NPV rule. Exactly why other capital budgeting techniques are used in practice is not always clear. Similar to NPV, the internal rate of return (IRR) investment rule, one of capital budgeting tools is based on the concept that the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with equivalent risk and maturity. In general, the IRR rule works for a stand-alone project if all of the project's negative cash flows precede its positive cash flows. In most cases, investment with high NPV will send to have higher IRR. However, in other cases, the IRR rule may disagree with the NPV rule and thus be incorrect. The conflict happened when mutually exclusive project has higher NPV but has lower IRR than the other project. This conflict can be solved by preparing NPV profile. Figure I and Figure 2 illustrate two different NPV Profile

(a) Based on the NPV profiles above, explain how this conflict (NPV 43. IRR) can be solved

(b) A survey found that a sizable minority of fimms (25%) in their study do not use the NPV rule at all. In addition, about 50% of firms surveyed used the payback rule. Furthermore, it appears that most firms use both the NPV rule and the IRR rule. Explain this phenomenon on why do firms use rules other than NPV if they can lead to erroneous decisions (5 marks)

Figure 1: NPV Profile 1 ric rang 100.000 $120,000 72.30 $4262 32.151 $100,000 972 $80,000 $60,000 om -1469 -14 -10.632 - 12.201 - 12,100 -10,547 -7732 -3523 1030 NPV $40,000 $20,000 IRR = 5.79% 11065 20.000 22.10 35.400 $0 596 1090 1596 2046 2546 30% 53.219 -$20,000 70,01 Cost of IRR = 13.80% Capital Discount Rate FIN222 (AA) / Pag Figure 2: NPV Profile 2 IRR for A = 19.43% IRR for B = 22.17% $160.00 $140.00 $120.00 $100.00 $80.00 Crossover Point = 11.8% $60.00 $40.00 $20.00 $0.00 ($20.00) ($40.00) 0.05 0.1 0.15 0.2 0.25 0.3 Discount Rate Figure 1: NPV Profile 1 ric rang 100.000 $120,000 72.30 $4262 32.151 $100,000 972 $80,000 $60,000 om -1469 -14 -10.632 - 12.201 - 12,100 -10,547 -7732 -3523 1030 NPV $40,000 $20,000 IRR = 5.79% 11065 20.000 22.10 35.400 $0 596 1090 1596 2046 2546 30% 53.219 -$20,000 70,01 Cost of IRR = 13.80% Capital Discount Rate FIN222 (AA) / Pag Figure 2: NPV Profile 2 IRR for A = 19.43% IRR for B = 22.17% $160.00 $140.00 $120.00 $100.00 $80.00 Crossover Point = 11.8% $60.00 $40.00 $20.00 $0.00 ($20.00) ($40.00) 0.05 0.1 0.15 0.2 0.25 0.3 Discount Rate