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Capital Budgeting

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7) X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows:

Year Project A Project B
1 $12,000 $10,000
2 8,000 6,000
3 6,000 16,000

a) Which of the two projects should be chosen based on the payback method?

b) Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

c) Should a firm normally have more confidence in answer a or b?

15) The Danforth Tire Company is considering the purchase of a new machine that would increase the speed of manufacturing and save money. The net cost of this machine is $66,000. The annual cash flows have the following projections:

Year Cash Flow
1 $21,000
2 29,000
3 36,000
4 16,000
5 8,000

a) If the cost of the capital is 10 percent, what is the net present value?

b) What is the rate of return?

c) Should the project be accepted? Why?

20) Miller Electronics is considering two new investments. Project C calls for the purchase of a coolant recovery system. Project H represents an investment in a heat recovery system. The firm wishes to use a net present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project C Project H
$25,000 Investment $25,000 Investment
Year Cash Flow Year Cash Flow
1 $6,000 1 $20,000
2 7,000 2 6,000
3 9,000 3 5,000
4 13,000

a) Determine the net present value of the projects based on a zero discount rate.

b) Determine the net present value of the projects based on a 9 percent discount rate.

c) The internal rate of return on Project C is 13.01 percent, and the internal rate of return on Project H is 15.68 percent. Graph a net present value profile for the two investments similar to figure 12-3. (Use a scale up to $10,000 on the vertical axis, with $2,000 increments. Use a scale up to 20 percent on the horizontal axis, with 5 percent increments.)

d) If the two projects are not mutually exclusive, what would your acceptance or rejection decision be if the cost of the capital (discount rate) is 8 percent/ (Use the net present value profile for your decision; no actual numbers are necessary.)

e) If the two projects are mutually exclusive (the selection of one precludes the selection of the other), what would your decision be if the cost of capital is (1) 5 percent, (2) 13 percent, (3) 19 percent? Use the net present value profile for your answer.

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The solution explains various questions relating to capital budgeting

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