Use the following information for problems 1 to 5. Assume that the projects are mutually exclusive.
Year
Cash Flow (A)
Cash Flow (B)
0
($1,525,600)
($1,425,600)
1
$683,100
$655,900
2
$480,200
$463,900
3
$745,000
$675,000
4
$308,000
$279,000
1. What is the IRR for each of these projects? Using the IRR decision rule, which project should the company accept? Is this decision necessarily correct?
2. If the required return is 13 percent, what is the NPV for each of these projects? Which project will the company choose if it applies the NPV decision rule?
3. Over what range of discount rates would the company choose Project A? Project B? At what discount rate would the company be indifferent between these two projects? Explain.
4. Compute the payback period for each project.
5. Compute the profitability index for each project.
Use the data below for problems 6 to 10.
Year
Proj Y
Proj Z
0
($210,000)
($210,000)
1
200,000
95,000
2
95,000
78,000
3
—
73,000
4
—
87,500
The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have an 11% cost of capital.
6. What is each project’s initial NPV without replication?
7. What is each project’s equivalent annual annuity?
8. Now apply the replacement chain approach to determine the shorter projects’ extended NPV. Which project should be chosen?
9. Now assume that the cost to replicate Project Y in 2 years will increase to $240,000 because of inflationary pressures. How should the analysis be handled now, and which project should be chosen?
10. You are also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the project’s estimated cash flows:
Yr
CF
Salvage
0
($89,000)
$89,000
1
31,200
48,000
2
45,400
39,000
3
52,750
0
Using the 13% cost of capital, what is the project’s NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the project’s optimal (economic) life?
11. Suppose you have a project that will cost $500,000 last for ten years. The cash flows for each year have an expected value of $100,000 with a standard deviation of $15,000. The cost of capital is 10%. Use a Monte Carlo simulation with 1,000 replications to evaluate this project using the NPV and IRR approaches. See the video below for constructing the Excel spreadsheet.
