Question

Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC (for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs, while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the units are shown here. Kim's WACC is 5.5%.

0

1

2

3

4

5

HCC	-$590,000	-$55,000	-$55,000	-$55,000	-$55,000	-$55,000
LCC	-$100,000	-$180,000	-$180,000	-$180,000	-$180,000	-$180,000

1. Which unit would you recommend?

   1. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since LCC's NPV of costs is lower than HCC's, LCC would be chosen.
   2. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since HCC's NPV of costs is lower than LCC's, HCC would be chosen.
   3. Since all of the cash flows are negative, the IRR's will be negative and we do not accept any project that has a negative IRR.
   4. Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.
   5. Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.

   -Select-IIIIIIIVV

2. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?

   1. The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.
   2. The IRR cannot be calculated because the cash flows are in the form of an annuity.
   3. The IRR of each project will be positive at a lower WACC.
   4. There are multiple IRR's for each project.
   5. The IRR of each project is negative and therefore not useful for decision-making.

   -Select-IIIIIIIVV

3. If the WACC rose to 11% would this affect your recommendation?

   1. When the WACC increases to 11%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.
   2. When the WACC increases to 11%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.
   3. Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.
   4. When the WACC increases to 11%, the NPV of costs are now lower for LCC than HCC.
   5. When the WACC increases to 11%, the NPV of costs are now lower for HCC than LCC.

   -Select-IIIIIIIVV

   Why do you think this result occurred?

   1. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.
   2. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.
   3. The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.
   4. The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.
   5. The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.

Answer 1

a)

Statement showing NPV of HCC

Year	Cash flow	PVIF @ 5.5%	PV
	A	B	C =A x B
0	-590000	1.0000	-590000
1	-55000	0.9479	-52133
2	-55000	0.8985	-49415
3	-55000	0.8516	-46839
4	-55000	0.8072	-44397
5	-55000	0.7651	-42082
PV of cash flow	-824866

Thus NPV of HCC = -824866 $

Statement showing NPV of LCC

Year	Cash flow	PVIF @ 5.5%	PV
	A	B	C =A x B
0	-100000	1.0000	-100000
1	-180000	0.9479	-170616
2	-180000	0.8985	-161721
3	-180000	0.8516	-153290
4	-180000	0.8072	-145299
5	-180000	0.7651	-137724
PV of cash flow	-868651

Thus NPV of LCC = -868651 $

Ans) II. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since HCC's NPV of costs is lower than LCC's, HCC would be chosen.

b) Ans) I. The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.

IRR is rate at which NPV is 0, since all the cash flow are negative , NPV will never become 0

c)

Statement showing NPV of HCC

Year	Cash flow	PVIF @ 11%	PV
	A	B	C =A x B
0	-590000	1.0000	-590000
1	-55000	0.9009	-49550
2	-55000	0.8116	-44639
3	-55000	0.7312	-40216
4	-55000	0.6587	-36230
5	-55000	0.5935	-32640
PV of cash flow	-793274

Thus NPV of HCC = -793274 $

Statement showing NPV of LCC

Year	Cash flow	PVIF @ 11%	PV
	A	B	C =A x B
0	-100000	1.0000	-100000
1	-180000	0.9009	-162162
2	-180000	0.8116	-146092
3	-180000	0.7312	-131614
4	-180000	0.6587	-118572
5	-180000	0.5935	-106821
PV of cash flow	-765261

Thus NPV of LCC = -765261 $

Ans) IV. When the WACC increases to 11%, the NPV of costs are now lower for LCC than HCC.

d) IV. The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.