414PART 5Long-Term Investment DecisionsSelf-Test Problem(Solutions in Appendix)LG 2LG 3ST101LG 4LG 5LG 6 All techniques with NPV profileMutually exclusive projects Fitch Industriesis in the process of choosing the better of two equal-risk, mutually exclusive capital expenditure projectsM and N. The relevant cash flows for each project are shown in the following table. The firms cost of capital is 14%.Project MProject NInitial investment (CF0)$28,500$27,000Year (t)Cash inflows (CFt)1$10,000$11,000210,00010,000310,0009,000410,0008,000Calculate each projects payback period. Calculate the net present value (NPV) for each project. Calculate the internal rate of return (IRR) for each project. Summarize the preferences dictated by each measure you calculated, and indicate which project you would recommend. Explain why. Draw the net present value profiles for these projects on the same set of axes, and explain the circumstances under which a conflict in rankings might exist. Warm-Up ExercisesAll problems are available in.LG 2 E101 Elysian Fields, Inc., uses a maximum payback period of 6 years and currently must choose between two mutually exclusive projects. Project Hydrogen requires an ini-tial outlay of $25,000; project Helium requires an initial outlay of $35,000. Using the expected cash inflows given for each project in the following table, calculate each projects payback period. Which project meets Elysians standards?Expected cash inflowsYearHydrogenHelium1$6,000$7,00026,0007,00038,0008,00044,0005,00053,5005,00062,0004,000CHAPTER 10Capital Budgeting Techniques415LG 3 E102 Herky Foods is considering acquisition of a new wrapping machine. The initialinvestment is estimated at $1.25 million, and the machine will have a 5-year lifewith no salvage value. Using a 6% discount rate, determine the net present value(NPV) of the machine given its expected operating cash inflows shown in thefollowing table. Based on the projects NPV, should Herky make this investment?YearCash inflow1$400,0002375,0003300,0004350,0005200,000LG 3E103 Axis Corp. is considering investment in the best of two mutually exclusive projects.Project Kelvin involves an overhaul of the existing system; it will cost $45,000 andgenerate cash inflows of $20,000 per year for the next 3 years. Project Thompsoninvolves replacement of the existing system; it will cost $275,000 and generate cashinflows of $60,000 per year for 6 years. Using an 8% cost of capital, calculate eachprojects NPV, and make a recommendation based on your findings.LG 4E104 Billabong Tech uses the internal rate of return (IRR) to select projects. Calculatethe IRR for each of the following projects and recommend the best project based onthis measure. Project T-Shirt requires an initial investment of $15,000 and generatescash inflows of $8,000 per year for 4 years. Project Board Shorts requires an initialinvestment of $25,000 and produces cash inflows of $12,000 per year for 5 years.LG 4LG 5E105 Cooper Electronics uses NPV profiles to visually evaluate competing projects. Keydata for the two projects under consideration are given in the following table. Usingthese data, graph, on the same set of axes, the NPV profiles for each project usingdiscount rates of 0%, 8%, and the IRR.TerraFirmaInitial investment$30,000$25,000YearOperating cash inflows1$ 7,000$6,000210,0009,000312,0009,000410,0008,000ProblemsAll problems are available in.LG 2 P101 Payback period Jordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax cash inflows of $7,000 per year for 10 years. The firm has a maximum acceptable payback period of 8 years.Determine the payback period for this project. Should the company accept the project? Why or why not? 416PART 5Long-Term Investment DecisionsLG 2 P102 Payback comparisons Nova Products has a 5-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choose between two alternative ones. The first machine requires an initial investment of $14,000 and generates annual after-tax cash inflows of $3,000 for each of the next 7 years. The second machine requires an initial investment of $21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years.Determine the payback period for each machine. Comment on the acceptability of the machines, assuming that they are inde-pendent projects. Which machine should the firm accept? Why? Do the machines in this problem illustrate any of the weaknesses of using pay-back? Discuss. LG 2 P103 Choosing between two projects with acceptable payback periods Shell Camping Gear, Inc., is considering two mutually exclusive projects. Each requires an initial investment of $100,000. John Shell, president of the company, has set a maximum payback period of 4 years. The after-tax cash inflows associated with each project are shown in the following table:Cash inflows (CFt)YearProject AProject B1$10,000$40,000220,00030,000330,00020,000440,00010,000520,00020,000Determine the payback period of each project. Because they are mutually exclusive, Shell must choose one. Which should the company invest in? Explain why one of the projects is a better choice than the other. Personal Finance ProblemLG 2 P104 Long-term investment decision, payback method Bill Williams has the opportunity to invest in project A that costs $9,000 today and promises to pay annual end-of-year payments of $2,200, $2,500, $2,500, $2,000, and $1,800 over the next 5 years. Or, Bill can invest $9,000 in project B that promises to pay annual end-of-year pay-ments of $1,500, $1,500, $1,500, $3,500, and $4,000 over the next 5 years.How long will it take for Bill to recoup his initial investment in project A? How long will it take for Bill to recoup his initial investment in project B? Using the payback period, which project should Bill choose? Do you see any problems with his choice? LG 3 P105 NPV Calculate the net present value (NPV) for the following 20-year projects. Comment on the acceptability of each. Assume that the firm has an opportunity cost of 14%.Initial investment is $10,000; cash inflows are $2,000 per year. Initial investment is $25,000; cash inflows are $3,000 per year. Initial investment is $30,000; cash inflows are $5,000 per year. CHAPTER 10Capital Budgeting Techniques417LG 3 P106 NPV for varying costs of capital Dane Cosmetics is evaluating a new fragrance-mixing machine. The machine requires an initial investment of $24,000 and will generate after-tax cash inflows of $5,000 per year for 8 years. For each of the costs of capital listed, (1) calculate the net present value (NPV), (2) indicate whether to accept or reject the machine, and (3) explain your decision.The cost of capital is 10%. The cost of capital is 12%. The cost of capital is 14%. LG 3P107Net present valueIndependent projects Using a 14% cost of capital, calculate thenet present value for each of the independent projects shown in the following table,and indicate whether each is acceptable.Project AProject BProject CProject DProject EInitial investment (CF0)$26,000$500,000$170,000$950,000$80,000Year (t)Cash inflows (CFt)1$4,000$100,000$20,000$230,000$024,000120,00019,000230,000034,000140,00018,000230,000044,000160,00017,000230,00020,00054,000180,00016,000230,00030,00064,000200,00015,000230,000074,00014,000230,00050,00084,00013,000230,00060,00094,00012,00070,000104,00011,000LG 3P108NPV Simes Innovations, Inc., is negotiating to purchase exclusive rights to manu-facture and market a solar-powered toy car. The cars inventor has offered Simes the choice of either a one-time payment of $1,500,000 today or a series of five year-end payments of $385,000.If Simes has a cost of capital of 9%, which form of payment should it choose? What yearly payment would make the two offers identical in value at a cost of capital of 9%? Would your answer to part a of this problem be different if the yearly payments were made at the beginning of each year? Show what difference, if any, that change in timing would make to the present value calculation. The after-tax cash inflows associated with this purchase are projected to amount to $250,000 per year for 15 years. Will this factor change the firms decision about how to fund the initial investment? LG 3 P109 NPV and maximum return A firm can purchase a fixed asset for a $13,000 initial investment. The asset generates an annual after-tax cash inflow of $4,000 for 4 years.Determine the net present value (NPV) of the asset, assuming that the firm has a 10% cost of capital. Is the project acceptable? Determine the maximum required rate of return (closest whole-percentage rate) that the firm can have and still accept the asset. Discuss this finding in light of your response in part a. 418PART 5Long-Term Investment DecisionsLG 3 P1010 NPVMutually exclusive projectsHook Industries is considering the replacementof one of its old drill presses. Three alternative replacement presses are under consid-eration. The relevant cash flows associated with each are shown in the followingtable. The firms cost of capital is 15%.Press APress BPress CInitial investment (CF0)$85,000$60,000$130,000Year (t)Cash inflows (CFt)1$18,000$12,000$50,000218,00014,00030,000318,00016,00020,000418,00018,00020,000518,00020,00020,000618,00025,00030,000718,00040,000818,00050,000Calculate the net present value (NPV) of each press. Using NPV, evaluate the acceptability of each press. Rank the presses from best to worst using NPV. Calculate the profitability index (PI) for each press. Rank the presses from best to worst using PI. Personal Finance ProblemLG 3P1011 Long-term investment decision, NPV methodJenny Jenks has researched the finan-cial pros and cons of entering into an elite MBA program at her state university.The tuition and needed books for a masters program will have an upfront cost of$100,000. On average, a person with an MBA degree earns an extra $20,000 peryear over a business career of 40 years. Jenny feels that her opportunity cost of cap-ital is 6%. Given her estimates, find the net present value (NPV) of entering thisMBA program. Are the benefits of further education worth the associated costs?LG 2LG 3P1012 Payback and NPV Neil Corporation has three projects under consideration. Thecash flows for each project are shown in the following table. The firm has a 16%cost of capital.Project AProject BProject CInitial investment (CF0)$40,000$40,000$40,000Year (t)Cash inflows (CFt)1$13,000$ 7,000$19,000213,00010,00016,000313,00013,00013,000413,00016,00010,000513,00019,0007,000CHAPTER 10Capital Budgeting Techniques419Calculate each projects payback period. Which project is preferred according to this method? Calculate each projects net present value (NPV). Which project is preferred according to this method? Comment on your findings in parts a and b, and recommend the best project. Explain your recommendation. LG 3 P1013 NPV and EVA A project costs $2.5 million up front and will generate cash flows in perpetuity of $240,000. The firms cost of capital is 9%.Calculate the projects NPV. Calculate the annual EVA in a typical year. Calculate the overall project EVA and compare to your answer in part a. LG 4P1014 Internal rate of returnFor each of the projects shown in the following table, calcu-late the internal rate of return (IRR). Then indicate, for each project, the maximumcost of capital that the firm could have and still find the IRR acceptable.Project AProject BProject CProject DInitial investment (CF0)$90,000$490,000$20,000$240,000Year (t)Cash inflows (CFt)1$20,000$150,000$7,500$120,000225,000150,0007,500100,000330,000150,0007,50080,000435,000150,0007,50060,000540,0007,500LG 4P1015 IRRMutually exclusive projects Bell Manufacturing is attempting to choosethe better of two mutually exclusive projects for expanding the firms warehousecapacity. The relevant cash flows for the projects are shown in the following table.The firms cost of capital is 15%.Project XProject YInitial investment (CF0)$500,000$325,000Year (t)Cash inflows (CFt)1$100,000$140,0002120,000120,0003150,00095,0004190,00070,0005250,00050,000Calculate the IRR to the nearest whole percent for each of the projects. Assess the acceptability of each project on the basis of the IRRs found in part a. Which project, on this basis, is preferred? 420LG 3LG 3 PART 5Long-Term Investment DecisionsPersonal Finance ProblemLG 4P1016Long-term investment decision, IRR method Billy and Mandy Jones have $25,000to invest. On average, they do not make any investment that will not return at least7.5% per year. They have been approached with an investment opportunity thatrequires $25,000 upfront and has a payout of $6,000 at the end of each of the next5 years. Using the internal rate of return (IRR) method and their requirements,determine whether Billy and Mandy should undertake the investment.LG 4P1017IRR, investment life, and cash inflows Oak Enterprises accepts projects earningmore than the firms 15% cost of capital. Oak is currently considering a 10-yearproject that provides annual cash inflows of $10,000 and requires an initial invest-ment of $61,450. (Note: All amounts are after taxes.)Determine the IRR of this project. Is it acceptable? Assuming that the cash inflows continue to be $10,000 per year, how many additional years would the flows have to continue to make the project acceptable (that is, to make it have an IRR of 15%)? With the given life, initial investment, and cost of capital, what is the minimum annual cash inflow that the firm should accept? LG 4 P1018 NPV and IRR Benson Designs has prepared the following estimates for a long-term project it is considering. The initial investment is $18,250, and the project is expected to yield after-tax cash inflows of $4,000 per year for 7 years. The firm has a 10% cost of capital.Determine the net present value (NPV) for the project. Determine the internal rate of return (IRR) for the project. Would you recommend that the firm accept or reject the project? Explain your answer. LG 4 P1019 NPV, with rankings Botany Bay, Inc., a maker of casual clothing, is considering four projects. Because of past financial difficulties, the company has a high cost of capital at 15%. Which of these projects would be acceptable under those cost circumstances?Project AProject BProject CProject DInitial investment (CF0)$50,000$100,000$80,000$180,000Year (t)Cash inflows (CFt)1$20,000$35,000$20,000$100,000220,00050,00040,00080,000320,00050,00060,00060,000Calculate the NPV of each project, using a cost of capital of 15%. Rank acceptable projects by NPV. Calculate the IRR of each project, and use it to determine the highest cost of capital at which all of the projects would be acceptable. CHAPTER 10Capital Budgeting Techniques421LG 2LG 3P1020 All techniques, conflicting rankingsNicholson Roofing Materials, Inc., is consid-LG 4ering two mutually exclusive projects, each with an initial investment of $150,000.The companys board of directors has set a maximum 4-year payback requirementand has set its cost of capital at 9%. The cash inflows associated with the twoprojects are shown in the following table.Cash inflows (CFt)YearProject AProject B1$45,000$75,000245,00060,000345,00030,000445,00030,000545,00030,000645,00030,000a. Calculate the payback period for each project.b. Calculate the NPV of each project at 0%.c. Calculate the NPV of each project at 9%.d. Derive the IRR of each project.e. Rank the projects by each of the techniques used. Make and justify a recommen-dation.LG 2LG 3P1021 Payback, NPV, and IRR Rieger International is attempting to evaluate the feasi-LG 4bility of investing $95,000 in a piece of equipment that has a 5-year life. The firmhas estimated the cash inflows associated with the proposal as shown in thefollowing table. The firm has a 12% cost of capital.Year (t)Cash inflows (CFt)1$20,000225,000330,000435,000540,000Calculate the payback period for the proposed investment. Calculate the net present value (NPV) for the proposed investment. Calculate the internal rate of return (IRR), rounded to the nearest whole percent, for the proposed investment. Evaluate the acceptability of the proposed investment using NPV and IRR. What recommendation would you make relative to implementation of the project? Why? LG 3LG 4P1022 NPV, IRR, and NPV profiles Thomas Company is considering two mutually exclu-LG 5sive projects. The firm, which has a 12% cost of capital, has estimated its cash flowsas shown in the following table.422PART 5Long-Term Investment DecisionsProject AProject BInitial investment (CF0)$130,000$85,000Year (t)Cash inflows (CFt)1$25,000$40,000235,00035,000345,00030,000450,00010,000555,0005,000Calculate the NPV of each project, and assess its acceptability. Calculate the IRR for each project, and assess its acceptability. Draw the NPV profiles for both projects on the same set of axes. Evaluate and discuss the rankings of the two projects on the basis of your find-ings in parts a, b, and c. Explain your findings in part d in light of the pattern of cash inflows associated with each project. LG 2LG 3P1023 All techniquesDecision among mutually exclusive investmentsPound IndustriesLG 4LG 5is attempting to select the best of three mutually exclusive projects. The initialinvestment and after-tax cash inflows associated with these projects are shown in theLG 6following table.Cash flowsProject AProject BProject CInitial investment (CF0)$60,000$100,000$110,000Cash inflows (CFt), t = 1 to 5$20,000$ 31,500$ 32,500a.Calculate the payback period for each project.b.Calculate the net present value (NPV) of each project, assuming that the firm hasa cost of capital equal to 13%.c.Calculate the internal rate of return (IRR) for each project.d.Draw the net present value profiles for both projects on the same set of axes, anddiscuss any conflict in ranking that may exist between NPV and IRR.e.Summarize the preferences dictated by each measure, and indicate which projectyou would recommend. Explain why.LG 2LG 3P1024 All techniques with NPV profileMutually exclusive projectsProjects A and B, ofLG 4LG 5equal risk, are alternatives for expanding Rosa Companys capacity. The firms costof capital is 13%. The cash flows for each project are shown in the following table.LG 6a.Calculate each projects payback period.b.Calculate the net present value (NPV) for each project.c.Calculate the internal rate of return (IRR) for each project.d.Draw the net present value profiles for both projects on the same set of axes, anddiscuss any conflict in ranking that may exist between NPV and IRR.e.Summarize the preferences dictated by each measure, and indicate which projectyou would recommend. Explain why.CHAPTER 10Capital Budgeting Techniques423Project AProject BInitial investment (CF0)$80,000$50,000Year (t)Cash inflows (CFt)1$15,000$15,000220,00015,000325,00015,000430,00015,000535,00015,000LG 6 P1025 IntegrativeMultiple IRRs Froogle Enterprises is evaluating an unusual invest-ment project. What makes the project unusual is the stream of cash inflows and out-flows shown in the following table:YearCash flow0$ 200,0001- 920,00021,582,0003- 1,205,2004343,200a.Why is it difficult to calculate the payback period for this project?b.Calculate the investments net present value at each of the following discountrates: 0%, 5%, 10%, 15%, 20%, 25%, 30%, 35%.c.What does your answer to part b tell you about this projects IRR?d.Should Froogle invest in this project if its cost of capital is 5%? What if the costof capital is 15%?e.In general, when faced with a project like this, how should a firm decide whetherto invest in the project or reject it?LG 3LG 4 P1026 IntegrativeConflicting Rankings The High-Flying Growth Company (HFGC) hasLG 5been growing very rapidly in recent years, making its shareholders rich in the process.The average annual rate of return on the stock in the last few years has been 20%, andHFGC managers believe that 20% is a reasonable figure for the firms cost of capital.To sustain a high growth rate, the HFGC CEO argues that the company must con-tinue to invest in projects that offer the highest rate of return possible. Two projectsare currently under review. The first is an expansion of the firms production capacity,and the second project involves introducing one of the firms existing products into anew market. Cash flows from each project appear in the following table.a.Calculate the NPV, IRR, and PI for both projects.b.Rank the projects based on their NPVs, IRRs, and PIs.c.Do the rankings in part b agree or not? If not, why not?d.The firm can only afford to undertake one of these investments, and the CEOfavors the product introduction because it offers a higher rate of return (that is, ahigher IRR) than the plant expansion. What do you think the firm should do? Why?424PART 5Long-Term Investment DecisionsYearPlant expansionProduct introduction0- $3,500,000- $500,00011,500,000250,00022,000,000350,00032,500,000375,00042,750,000425,000LG 1LG 6 P1027 ETHICS PROBLEM Gap, Inc., is trying to incorporate human resource and supplierconsiderations into its management decision making. Here is Gaps report of find-ings from a recent Social Responsibility Report:Because factory owners sometimes try to hide violations, Gap emphasizes trainingfor factory managers. However, due to regional differences, the training varies fromone site to another. The report notes that 10 to 25 percent of workers in China,Taiwan, and Saipan have been harassed and humiliated. Less than half of the facto-ries in sub-Saharan Africa have adequate worker safety regulations and infrastruc-ture. In Mexico, Latin America, and the Caribbean, 25 to 50 percent of the suppliersfail to pay even the minimum wage.Calvert Group, Ltd., a mutual fund family that focuses on socially responsibleinvesting, had this to say about the impact of Gaps report:With revenues of $15.9 billion and over 300,000 employees worldwide, Gap leadsthe U.S. apparel sector and has contracts with over 3,000 factories globally. Calverthas been in dialogue with Gap for about five years, the last two as part of theWorking Group.Gaps supplier monitoring program focuses on remediation, because its sup-pliers produce for multiple apparel companies and would likely move their capacityto different clients rather than adopt conditions deemed too demanding. About one-third of the factories Gap examined comfortably met Gaps criteria, another thirdhad barely acceptable conditions, and the final third missed the minimum standards.Gap terminated contracts with 136 factories where it found conditions to be beyondremediation.Increased transparency and disclosure are crucial in measuring a companyscommitment to raising human rights standards and improving the lives of workers.Gaps report is an important first step in the direction of a model format that othercompanies can adapt.8If Gap were to aggressively pursue renegotiations with suppliers, based on thisreport, what is the likely effect on Gaps expenses in the next 5 years? In youropinion, what would be the impact on its stock price in the immediate future? After10 years?8. www.calvert.com/news_newsArticle.asp?article=4612&image=cn.gif&keepleftnav=Calvert+News