1. A firm is considering two mutually exclusive investments, each with an initial outlay of $10,000 and an expected life of 3 years. Assume that the firm has a cost of capital of
12 percent for each project. The two investments are of equal risk and have the following cash flows:
Investment A Investment B
Cash Flow Cash Flow
Year 0 $10,000 $10,000
Year 1 $4,000 $6,000
Year 2 $5,000 $6,000
Year 3 $11,000 $6,000
Calculate the payback period and the net present value for each investment. Show your calculations.
2. Based on the NPV and payback period calculations, which investment should the firm choose? Why? (20 points)
3. When calculating a firm’s cost of capital, why is there a cost associated with retained earnings? (6 points)
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