An analysis of NPV and IRR for the Project

Subsection a:

Use the discounting factor of 10% (cost of capital) the NPV is as shown below

NPV is $-23.9392, which implies that the project will not break-even within the period

Question b

Using the excel and the IRR function, the value of IRR is 6%. This value is less than the cost of capital of 10% and that explains why the NPV is negative.

Question c

The IRR rule states that a project should be accepted only if the value of IRR exceeds the cost of capital, otherwise the management should not undertake the project. In this case the value of IRR is 6% which is lower than the cost of capital of 10%. IRR rule is applicable as the NPV shows that the project is not economically viable.

Question c

Borrowing amortization schedule

Question d

The IRR is 304%

Question e

The NPV is now positive at 77.4378 this is consistent with the positive IRR. The cash used by the company is $20 and the rest amount was borrowed and repaid. Positive NPV shows positive cash flows for the company.

Question f

BU should go ahead with the project as it will get value out of investing in it.

Subsection a

This is not true. Though interest lowers the companies tax bills, it also increases the cost of operations and lowers profitability. Borrowings exposes a company to possible litigations if it fails to repay the borrowed amount and interests’ instalment in a timely basis. In addition, debts lower a company liquidity as money paid out as interest reduces a company’s cash flows. Considering these factors debts should be used for financing only when an organization derives higher benefits than the cost of debt. Therefore, maximum borrowings should only be recommended when the company derives higher value from borrowed capital than the cost paid to the financing institution as interests.

Subsection b

The statement is not true. Both debt and equity have advantages and disadvantages. The management should use a financing options that aligns with its financing objectives. For instance, if the gearing ratio of a company is high, it will be prudent to use equity financing to reduce the risk of debt exposure and cost of financing debts.

Subsection c

The NPV method is often faced with the challenge of examining the actual risk premium associated with undertaking a project. The uncertainty in the risk premium implies that the final discounting rate used while evaluating the whether to undertake a project or not may not be calculated with precision. The real value that an investors will get from a project may deviate from the anticipated value due to uncertainties surrounding assessment of the correct risk premium.

Subsection C

The statement is true. Betas measures volatility of a market price of a stock. Company with lower beta values shows that their stock prices are stable compared to the general trend of market. Their stability enables them to acquire a target at an attractive price as the owners of the target are likely to sell their shares to a company with a stable movement in its stock prices. Companies with higher betas will not attract investors whose stock has higher betas as there is no advantage attached to becoming acquired by such a company. Companies with higher betas introduces additional risk to a company with higher betas and they can only wish to buy them at lower prices to absorb the existing risk in the acquired firm.

The statement is true. Low leveraged companies have low levels of borrowings compared to equity. As a result, the lenders consider the management to be confident of the project they intend to undertake as they have already committed a significant portion of capital towards those projects. Therefore, if the project fails, the shareholders stand to lose more than the lenders and it is unlikely they could commit a significant amount of resource on a project bound to fail.