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1) Acme corp is looking at two investments, both 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 two projects should be chosen based on the payback method?
b. Which two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.
c. Should a firm have more confidence in answer a or answer b?
2)
Rector Inc. 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 capital is 10 percent, what is the net present value?
b. What is the internal rate of return?
c. Should the project be accepted? Why?
3.
Delco inc. 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
($25,000 investment)
Year Cash Flow
1 $ 6,000
2 7,000
3 9,000
4 13,000
Project H
($25,000 investment)
Year Cash Flow
1 $20,000
2 6,000
3 5,000
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 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 be your decision 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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Question 1
a. The payback period is the time that it takes for the cash flows of the project to cover the project's initial expenses. When using the payback method, the project with the lowest payback period should be chosen.
In this case, the initial investment is $10,000. As you can see from the cash flows, both projects cover these costs in year 1. However, since project A returns $12,000 in the whole year (12 months), we can expect it to return the $10,000 in just 10 months. Therefore, project A should be chosen.
b. The PV method consists of comparing the present values of the cash flows of both projects and choosing the one with the highest one PV, but only if it is greater than zero. If all projects have a an NPV of less than zero, then none should be chosen.
The formula for present value is:
C0 + C1/(1+r) + C2/(1+r)^2 + C3/(1+r)^3 + ...
where r is the interest rate (in this case, r =0.1), and C0, C1, C2... are the cash flows in year 0 (investment), year 1, year2, etc.
Since it's a bit tedious do it by ...
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