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Chapter 4: Q21BP (page 411)

The Caffeine Coffee Company uses the modified internal rate of return. The firm has a cost of capital of 11 percent. The project being analyzed is as follows (\(26,000 investment):

Year

Cash flow

1

\)12,000

2

11,000

3

9,000

a. What is the modified internal rate of return? An approximation from Appendix B is adequate. (You do not need to interpolate.)

b. Assume the traditional internal rate of return on the investment is 17.5 percent. Explain why your answer in part a would be lower.

Short Answer

Expert verified

Answer

  1. Modified internal rate of return:12%.

  2. The answer in part (a) is lower because the re-investment is made at the cost of capital rate.

Step by step solution

01

Definition of Internal Rate of Return

The internal rate of return can be defined as one method used to calculate the rate at which investment provides a return to the investor. It determines the profitability of the business entity.

02

Modified Internal rate of return

Calculation of terminal value:

Year

Cash flow

Period of growth

FV factor 11%

Future value

Year 1

$12,000

2

1.232

$14,784

Year 2

11,000

1

1.11

12,210

Year 3

9,000

0

1

9,000





$35,994

Calculation of yield of investment:

PVIF=PresentvalueFuturevalue=$26,000$35,994=0.722

Now we will use Appendix B:

For n=3, the answer will be 12% (approx.).

03

Explanation for lower IRR in part a

The answer in part a. is lower because, under the modified internal rate of return, it is assumed that the cash inflows from the investment are reinvested at the cost of capital, i.e., 11%. At the same time, under the traditional internal rate of return, the cash flows are assumed to be invested at 17.5%.

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Most popular questions from this chapter

Christy Reed made a \(2,000 deposit in her savings account on her 21st birthday, and she has made another \)2,000 deposit on every birthday since then. Her account earns 7 percent compounded annually. How much will she have in the account after she makes the deposit on her 32nd birthday?

What are the basic benefits and purposes of developing pro forma statements and a cash budget?

Juan Garza invested $20,000 10 years ago at 12 percent, compounded quarterly. How much has he accumulated?

Question:Beasley Ball Bearings paid a \(4 dividend last year. The dividend is expected to grow at a constant rate of 2 percent over the next four years. The required rate of return is 15 percent (this will also serve as the discount rate in this problem). Round all values to three places to the right of the decimal point where appropriate.

a. Compute the anticipated value of the dividends for the next four years. That is, compute D1, D2, D3, and D4; for example, D1 is \)4.08 (\(4 3 1.02).

b. Discount each of these dividends back to present at a discount rate of 15 percent and then sum them.

c. Compute the price of the stock at the end of the fourth year (P4). P4 5 D5 ______ Ke 2 g (D5 is equal to D4 times 1.02.)

d. After you have computed P4, discount it back to the present at a discount rate of 15 percent for four years.

e. Add together the answers in part b and part d to get P0, the current value of the stock. This answer represents the present value of the four periods ofdividends, plus the present value of the price of the stock after four periods (which in turn represents the value of all future dividends).

f. Use Formula 10-8 to show that it will provide approximately the same answer as part e. P0 5 D1 ______ Ke 2 g For Formula 10-8, use D1 5 \)4.08, Ke 5 15 percent, and g 5 2 percent. (The slight difference between the answers to part e and part f is due to rounding.)

g. If current EPS were equal to $4.98 and the P/E ratio is 1.2 times higher than the industry average of 6, what would the stock price be?

h. By what dollar amount is the stock price in part g different from the stock price in part f?

i. In regard to the stock price in part f, indicate which direction it would move if (1) D1 increases, (2) Ke increases, and (3) g increases

How is the supernormal growth pattern likely to vary from the normal, constant growth pattern?
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