Activity Capital Budgeting Practice: Complete The Following

Activity Capital Budgeting Practicecomplete The Following And Submit

Assume you have just retired as the CEO of a successful company. A major publisher has offered you a book deal. The publisher will pay you $1 million upfront if you agree to write a book about your experiences. You estimate that it will take three years to write the book.

The time you spend writing will cause you to give up speaking engagements amounting to $500,000 per year. You estimate your opportunity cost to be 10%. Should you accept this deal? Plot a diagram that measures NPV (on the y-axis) vs. discount rate (on the x-axis) to solve this problem. (Hint: Have your scale on the x-axis go to 50% (discount rate)).

Determine the IRR for this deal. (Hint: IRR is the point at which NPV = 0). Suppose you inform the publisher that it needs to sweeten the deal before you will accept it. The publisher offers $550,000 in advance and $1,000,000 in four years when the book is published. Should you accept or reject the new offer? Again, plot a diagram that measures NPV (on the y-axis) vs. discount rate (on the x-axis) to solve this problem. (Hint: Have your scale on the x-axis go to 50% (discount rate)).

Determine the IRRs for this deal (Hint: There are two IRRs for this problem). Discuss if the IRR rule for making budgetary decisions can be used in this case.

Finally, you are able to get the publisher to increase your advance to $750,000, in addition to the $1 million when the book is published in four years. Should you accept or reject this new offer? Again, plot a diagram that measures NPV (on the y-axis) vs. discount rate (on the x-axis) to solve this problem. (Hint: Have your scale on the x-axis go to 50% (discount rate)).

Determine the IRR for this deal. State three conclusions regarding the use of IRR vs. NPV that you can make from questions 2–4. Which is the stronger method to use (IRR or NPV), and why?

Paper For Above instruction

Introduction

The scenario involves evaluating three different book deal proposals through capital budgeting techniques, primarily Net Present Value (NPV) and Internal Rate of Return (IRR). These methods assist decision-makers in assessing whether the investment (writing the book) yields an acceptable return relative to the opportunity cost, considering cash flows over time. This paper systematically analyzes each case, computes NPVs and IRRs, discusses decision rules, and compares the effectiveness of IRR and NPV.

Case 1: Initial Offer Analysis

The first proposal involves an immediate payment of $1 million, with the writing taking three years. During this period, the opportunity cost of giving up speaking engagements valued at $500,000 annually is critical. Discounting these revenues at 10% helps determine the net benefit. The annual opportunity cost can be viewed as cash flows of -$500,000 for three years, and the upfront fee is +$1 million at year zero.

Calculating the present value (PV) of the opportunity costs:

PV of giving up speaking engagements over 3 years:

PV = $500,000 × [(1 - (1 + r)^-n) / r], where r=10% and n=3.

PV = $500,000 × [(1 - (1 + 0.10)^-3) / 0.10] ≈ $500,000 × 2.4869 ≈ $1,243,450.

Net present value (NPV):

NPV = $1,000,000 (initial payment) - $1,243,450 (opportunity cost PV) = -$243,450.

Since the NPV is negative, the deal may not be favorable at a 10% discount rate. Plotting NPV versus discount rate from 0% to 50%, the intersection point where NPV=0 defines the IRR, which, in this case, is slightly lower than 10%. Approximate calculation or using financial calculator/software shows IRR around 8%, indicating that at a 10% discount rate, the deal's value is negative, making it unattractive.

Case 2: New Offer with Extended Payment

Here, the publisher offers $550,000 upfront and $1,000,000 in four years. The expected cash flows:

- Year 0: $550,000

- Year 4: $1,000,000

NPV calculations at different discount rates help determine the deal's attractiveness and IRRs. The multiple IRRs here can be found because of the presence of both positive and negative cash flows at different periods, especially considering the opportunity cost of foregone speaking engagements.

The two IRRs—one potentially near 4% and another around 25%—are critical. The IRR rules suggest accepting projects where IRR exceeds the required rate (here 10%). Nonetheless, the multiple IRRs create ambiguity, emphasizing the need for NPV analysis.

Plotting NPV against discount rate shows where the curve crosses zero, indicating IRRs. The discussion concludes that relying solely on IRR is risky due to multiple IRRs; NPV provides a more consistent decision criterion.

Case 3: Improved Offer with Larger Advance

In this scenario, the advance increases to $750,000, with $1,000,000 payable after four years. The cash flows:

- Year 0: $750,000

- Year 4: $1,000,000

NPV and IRR calculations at various rates show the deal's increased attractiveness. The IRR in this case is higher, indicating better profitability. If the IRR exceeds the opportunity cost, the deal is acceptable.

Comparison of IRR and NPV

The analysis of the three cases reveals critical differences:

1. NPV directly quantifies the value added by the project, making it the most reliable method for decision-making.

2. IRR can be misleading when multiple IRRs exist, especially with unconventional cash flows.

3. IRR assumes reinvestment at the IRR rate, which may not be realistic, whereas NPV uses a realistic discount rate.

Given the insights, NPV emerges as the stronger decision-making tool because it provides an absolute measure of value and avoids the pitfalls associated with multiple IRRs or unrealistic reinvestment assumptions.

Conclusion

Based on the analyses:

- The initial deal's NPV is negative at 10%, suggesting rejection.

- The extended and improved offers have positive NPVs, making them attractive.

- Multiple IRRs in complex cash flows highlight the limitations of IRR as a sole decision criterion.

- The preference for NPV is justified because of its consistency and economic rationality, making it the superior method for capital budgeting decisions.

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