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Chapter 4: Q6DQ (page 405)

How does the modified internal rate of return include concepts from both the traditional internal rate of return and the net present value methods? (LO12-4)

Short Answer

Expert verified

Answer

  1. Modified and traditional internal rate of return equalizes the initial investment and future cash inflows.

  2. Modified IRR and NPV both implement re-investment rate assumptions.

Step by step solution

01

Definition of Internal Rate of Return

Internal rate of return is the rate which help the company to determine the profitability of the initial investment made by the business entity. It is calculated using the same formula as NPV is calculated.

02

Modified internal rate of return

The modified internal rate of return calculates the interest rates that will equalize the future inflows from the investment and the potential investment. This is done by the traditional internal rate of return. Modified internal rate of return also includes the reinvestment rate assumption used in net present value, which means that the project鈥檚 inflows are reinvested at the cost of capital.

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Most popular questions from this chapter

Dixie Dynamite Company is evaluating two methods of blowing up old buildings for commercial purposes over the next five years. Method one (implosion) is relatively low in risk for this business and will carry a 12 percent discount rate. Method two (explosion) is less expensive to perform but more dangerous and will call for a higher discount rate of 16 percent. Either method will require an initial capital outlay of \(75,000. The inflows from projected business over the next five years are shown next. Which method should be selected using net present value analysis?

Year Method 1 Method 2

1 .................................... \)18,000 $20,000

2 .................................... 24,000 25,000

3 .................................... 34,000 35,000

4 .................................... 26,000 28,000

5 .................................... 14,000 15,00

Using Table 10-2:

a. Assume the interest rate in the market (yield to maturity) goes down to 8 percent for the 10 percent bonds. Using column 2, indicate what the bond price will be with a 10-year, a 15-year, and a 20-year time period.

b. Assume the interest rate in the market (yield to maturity) goes up to 12 percent for the 10 percent bonds. Using column 3, indicate what the bond price will be with a 10-year, a 15-year, and a 20-year period.

c. Based on the information in part a, if you think interest rates in the market are going down, which bond would you choose to own?

d. Based on information in part b, if you think interest rates in the market are going up, which bond would you choose to own?

If risk is to be analyzed in a qualitative way, place the following investment decisions in order from the lowest risk to the highest risk: (LO13-1)

a. New equipment.

b. New market.

c. Repair of old machinery.

d. New product in a foreign market.

e. New product in a related market.

f. Addition to a new product line.

You are going to receive $205,000 in 18 years. What is the difference in present value between using a discount rate of 12 percent versus 9 percent?

You are asked to evaluate the following two projects for the Norton Corporation. Using the net present value method combined with the profitability index approach described in footnote 2 of this chapter, which project would you select? Use a discount rate of 14 percent.

Project X (Videotapes of the Weather Report) (\(20,000 Investment)

Year

Cash Flow

1

\)10,000

2

8,000

3

9,000

4

8,600

Project Y (Slow-Motion Replays of Commercials) (\(40,000 Investment)

Year

Cash Flow

1

\)20,000

2

13,000

3

14,000

4

16,000
See all solutions

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