Chapter 5 Calculating IRR 6. Compute the internal rate of return for the cash flows of the following projects. Cash Flows Year Project A Project B 0 -3,500 -2,300 1 1,800 900 2 2,400 1,600 3 1,900 1,400 8. Calculating Profitability Index; Suppose the following two independent investment opportunities are available to Green plain, Inc. The appropriate discount rate is 10 percent. Year Project Alpha Project Beta 0 -1,500 -2,500 1 800 500 2 900 1,900 3 700 2,100 a. Compute the profitability index for each of the two projects. b. Which project(s) should Green plain accept based on the profitability index rule? 11. NPV versus IRR Consider the following cash flow on two mutually exclusive projects for the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 14 percent. Year Deepwater Fishing New Submarine Ride 0 -750,000 -2,100,000 1 310,000 1,200,000 2 430,000 760,000 3 330,000 850,000 As a financial analyst for BRC, you are asked the following questions: a. If your decision rule is accept the project with the greater IRR, which project should you choose? b. Because you are fully aware of the IRR rule?s scale problem, you calculate the incremental IRR for the cash flows. Based on your computation, which project should you choose? c. To be prudent you compute the NPV for both projects. Which project should you choose? Is it consistent with the incremental IRR rule? 21. Payback and NPV An investment under consideration has a payback of sex years and a cost of $574,000. If the required return is 12 percent, what is the worst-case NPV? Explain. Assume cash flows are conventional 25. NPV and IRR Anderson International Limited is evaluating a project in Erewhon. The project will create the following cash flows: Year Cash flows 0 -750,000 1 205,000 2 265,000 3 346,000 4 220,000 All cash flows will occur in Erewhon and are expressed in dollars. In an attempt to improve its economy, the Erewhonian government has declared that all cash flows created by a foreign company are ?blocked? and must be reinvested with the government for one year. The reinvestment rate for these funds is 4 percent. If Anderson uses an 11 percent required return on this project, what are the NPV and IRR of the project? Is the IRR you calculated the MIRR of the project? Why or why not? Chapter 6 3. Calculating Project NPV Down Under Boomerang, Inc. is considering a new three year expansion project that requires an initial fixed asset investment of $2.4 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which it will be worthless. The project is estimated to generate $2,050,000 in annual sales, which costs of $950,000. The tax rate is 35 percent and the required return is 12 percent. What is the project?s NPV? 4. Calculating Project Cash Flow from Assets. In the previous problem, suppose the project requires an initial investment in net working capital of $285,000 and the fixed asset will have a market value of $225,000 at end of the project. What is the project?s year 0 net cash flow? Year 1? Year 2? Year 3? What is the new NPV? 14. Comparing Mutually Exclusive Projects Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,400,000 and will last for sex years. Variable costs are 35 percent sales, and fixed costs are $180,000 per year. Machine B costs $5,400,000 and will last for nine years. The sales for each machine will be $10.5 million per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis. If the company plans to replace the machine when it wears out on perpetual basis, which machine should you choose? 21. Calculating NPV and IRR for a Replacement. A firm is considering an investment in a new machine with a price of $12 million to replace its existing machine. The current machine has a book value of $4 million and a market value of $3 million. The new machine is expected to have a four-year life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine it expects to save $4.5 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of $ 250,000 in net working capital. The required return on the investment is 10 percent, and the tax rate is 39 percent. What are the NPV and IRR of the decision to replace the old machine? 34. Benson Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building that it has purchased for $850,000. The company can continue to rent the building to the present occupants for $36,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years. Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Benson?s production engineer feels the building could be adapted to handle one of two new product lines. The cost and revenue data for the two product alternatives are as follows. Product A Product B Initial cash outlay for building modifications 45,000 65,000 Initial cash outlay for equipment 165,000 205,000 Annual pretax cash revenues (generated for 15 yrs) 135,000 165,000 Annual pretax expenditures (generated for 15yrs) 60,000 75,000 The building will be used for only 15 years for either product A or product B. After 15 years the building will be too small for efficient production of either product line. At that time, Benson plans to rent the building to firms similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash cost of restoring the building if product A has been undertaken is $29,000. If product B has been manufactured, the cash cost will be $35,000. These cash costs can be deducted for tax purposes in the year the expenditures occur. Benson will depreciate the original building shell (purchased for $850,000) over a 30-year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have a 15-year life. They will be depreciated by the straight-line method. The firm?s tax rate is 34 percent, and its required rate of return on such investments is 12 percent. For simplicity, assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today (year 0), and the restoration outlays will occur at the end of year 15. Benson has other profitable ongoing operations that are sufficient to cover any losses. Which use of the building would you recommend to management?
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