Activity: Capital Budgeting Practice
Complete the following and submit it in a Word document. Be sure to show your process and calculations:
- 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 up front 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 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 NVP (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 NVP (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?
