Chapter 4: Q20BP (page 411)

Turner Video will invest $76,344 in a project. The firm’s cost of capital is 10 percent. The investment will provide the following inflows:
Year
Inflow
1
$15,000
2
17,000
3
21,000
4
25,000
5
29,000
The internal rate of return is 11 percent.
a. If the reinvestment assumption of the net present value method is used, what will be the total value of the inflows after five years? (Assume the inflows come at the end of each year.)
b. If the reinvestment assumption of the internal rate of return method is used, what will be the total value of the inflows after five years?
c. Generally is one investment assumption likely to be better than another?

Short Answer

Expert verified

Answer

Reinvestment assumption of the net present value method:$126,497.
Reinvestment assumption of the internal rate of return:$128,648.
No, investment assumption can be considered better than others.

Step by step solution

Definition of Profitability Index

The profitability index is the metric that determines the attractiveness of the different available projects to make an investment decision. Under this metric, the present value of the cash flows generated from the investment is compared with the initial investment.

Reinvestment assumption of the net present value method

Year	Inflows	Rate	Number of periods	Future value factor	Value
1	$15,000	10%	4	1.464	$21,960
2	17,000	10%	3	1.331	22,627
3	21,000	10%	2	1.21	25,410
4	25,000	10%	1	1.10	27,500
5	29,000		0	1	29,000
					$126,497

Reinvestment assumption of the internal rate of return

Year	Inflows	Rate	Number of periods	Future value factor	Value
1	$15,000	11%	4	1.518	$22,770
2	17,000	11%	3	1.368	23,256
3	21,000	11%	2	1.232	25,872
4	25,000	11%	1	1.11	27,750
5	29,000		0	1	29,000
					$128,648

Better investment assumption

One of the investment options cannot consider better than the other. But it can say that reinvestment at a net present value rate will provide more relevant information because it uses the cost of capital. It is not always possible to re-invest at a higher rate equal to IRR.

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Short Answer

Step by step solution

Definition of Profitability Index

Reinvestment assumption of the net present value method

Reinvestment assumption of the internal rate of return

Better investment assumption

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