ISL333E
FINANCE
Problem Session 6
Q1
A company is considering two mutually exclusive expansion plans. Plan A
requires a $40 million expenditure on a large-scale integrated plant that would
provide expected cash flows of $6.4 million per year for 20 years. Plan B
requires a $12 million expenditure to build a somewhat less efficient, more
labor-intensive plant with expected cash flows of $2.72 million per year for 20
years. The firm’s WACC is 10%.
Q1
a. Calculate each Project’s NPV and IRR.
b. Graph the NPV profiles Plan A and Plan B and approximate the crossover
rate.
c. Calculate the crossover rate where the two projects’ NPVs are equal.
d. Why is NPV better than IRR for making capital budgeting decisions that add
to shareholder value?
Q2
Your division is considering two projects. Its WACC is 10%, and the
projects’ after-tax cash flows (in millions of dollars) would be as
follows:
0 1 2 3 4
Project A -$30 $5 $10 $15 $20
Project B -$30 $20 $10 $8 $6
a. Calculate the projects’ NPVs, IRRs, MIRRs, regular paybacks, and
discounted paybacks.
b. If the two projects are independent, which Project(s) should be
chosen?
Q2
c. If the two projects are mutually exclusive and the WACC is 10%,
which Project(s) should be chosen?
d. Plot NPV profiles for the two projects. Identify the projects’ IRR on
the graph.
e. If the WACC was 5%, would this change your recommendation if the
projects were mutually exclusive? If the WACC was 15%, would this
change your recommendation? Explain your answers.
f. The crossover rate is 13.5252%. Explain that this rate is and how it
affects the choice between mutually exclusive projects.
g. Is it possible for conflicts to exist between the NPV and the IRR
when independent projects are being evaluated? Explain your
answers.
Q2
h. Now look at the regular and discounted paybacks. Which
Project looks better than judged by the paybacks?
i. If the payback was the only method a firm used to accept or
reject projects, what payback should it choose as the cutoff
point, that is, reject projects if their paybacks are not below the
chosen cutoff? Is your selected cutoff based on some economic
criteria, or is it more or less arbitrary? Are the cutoff criteria
equally arbitrary when firms use the NPV and/or the IRR as the
criteria? Explain.
Q2
j. Define the MIRR. What’s the difference between the IRR and the MIRR, and
which generally gives a better idea of the rate of return on the investment in a
Project?
k. Why do most academics and financial executives regard the NPV as being
the single best criterion and better than IRR? Why do companies still calculate
IRRs?
Q3
Holmes Manufacturing is considering a new machine that costs
$250000 and would reduce pretax manufacturing costs by
$90000 annually. Holmes would use the 3-year MACRS method
to depreciate the machine, and management thinks the machine
would have a value of $23000 at the end of its 5-year operating
life. The applicable depreciation rates are 33%, 45%, 15% and
7% as discussed in Appendix 12A. Net operating working capital
would increase by $25000 initially, but it would be recovered at
the end of the Project’s 5-year life.
Q3
Holmes’s marginal tax rate is 40%, and a 10% WACC is appropriate for the
Project.
a. Calculate the Project’s NPV, IRR, MIRR, and payback.
b. Assume management is unsure about the $90000 cost savings- this figure
could deviate by as much as plus or minus 20%. What would the NPV be
under each of these situations?
Q3
c. Suppose the CFO wants you to do a scenario analysis with different
values for the cost savings, the machine’s salvage value, and the net
opeating working capital (NOWC) requirement. She asks you to use
the following probabilities and values in the scenario analysis:
Scenario Probability Cost Salvage NOWC
Savings Value
Worst case 0.35 $72000 $18000 $30000
Base case 0.35 $90000 $23000 $25000
Best case 0.30 $108000 $28000 $20000
Calculate the project’s expected NPV, its standard deviation, and its
coefficient of variation. Would you recommend that the Project be
accepted? Why or why not?
Q4
Coiner Clothes Inc. is considering the replacement of its old, fully
depreciated knitting machine. Two new models are available: (a)
Machine 190-3, which has a cost of $190000, a 3-year expected life,
and after-tax cash flows (labor savings and depreciation) of $87000
per year, and (b) Machine 360-6, which has a cost of $360000, a 6-
year life, and after-tax cash flows of $98300 per year. Assume that
both projects can be repeated. Knitting machine prices are not
expected to rise because inflation will be offset by cheaper
components (microprocessors) used in the machines. Assume that
Cotner’s WACC is 14%. Using the replacement chain and EAA
approaches, which model should be selected? Why?
Q5
The Fernandez Company has an opportunity to invest in one
of two mutually exclusive machines that will produce a
product the company will need for the next 8 years. Machine
A costs $10 million but will provide after-tax inflows of $4
million per year of 4 years. If Machine A was replaced, its cost
would be $12 million due to inflation and its cash inflows
would increase to $4.2 million due to production efficiencies.
Machine B costs $15 million and will provide after-tax inflows
of $3.5 million per year for 8 years. If the WACC is 10%,
which machine should be acquired? Explain.