Reference no: EM13381071

Cash Flows ($)

Project                 C0                C1                C2     C3            C4                 C5          IRR (%)   NPV at 10%

F                        -9,000          +6,000           +5000            +4000         0                    0                   33           3,592

G                       -9,000          +1,800           +1,800           +1,800      +1,800       +1,800           20           9,000

H                          --             -6,000           +1,200           +1,200       +1,200        +1,200         20           6,000

1. Look back to the cash flows for projects F and G. The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are over- stated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects' sponsors, instructs them to use a discount rate of 18%.

a. What are the projects' true NPVs?

b. What are the NPVs at the 18% discount rate?

c. Are there any circumstances in which the 18% discount rate would give the correct NPVs? (Hint: Could upward bias be more severe for more-distant cash flows?)

Otobai's accounting profit:

Unit Sales            Revenues            Variable               Fixed     Depreciation      Taxes    Total      Profit

(thousands)       Years 1-10           Costs                     Costs                                                     Costs     after Tax

0                         0                              0                         3                   1.5                     -2.25      2.25        -2.25

100                     37.5                        30                           3                   1.5                       1.5        36.0        1.5

200                     75.0                        60                           3                   1.5                       5.25      69.75     5.25

Suppose that the expected variable costs of Otobai's project are ¥33 billion a year and that fixed costs are zero. How does this change the degree of operating leverage? Now recompute the operating leverage assuming that the entire ¥33 billion of costs are fixed.