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	-$600,000	-$50,000	-$50,000	-$50,000	-$50,000	-$50,000
LCC	-$110,000	-$170,000	-$170,000	-$170,000	-$170,000	-$170,000

1. Which unit would you recommend?

   1. Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.
   2. 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.
   3. 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.
   4. 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.
   5. 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.

   -Select-IIIIIIIVVItem 1

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 in the form of an annuity.
   2. The IRR of each project will be positive at a lower WACC.
   3. There are multiple IRR's for each project.
   4. The IRR of each project is negative and therefore not useful for decision-making.
   5. 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.

   -Select-IIIIIIIVVItem 2

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

   1. When the WACC increases to 11%, the NPV of costs are now lower for LCC than HCC.
   2. When the WACC increases to 11%, the NPV of costs are now lower for HCC than LCC.
   3. When the WACC increases to 11%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.
   4. When the WACC increases to 11%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.
   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-IIIIIIIVVItem 3

   Why do you think this result occurred?

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

   -Select-IIIIIIIVV

Answer 1

a)

Statement showing NPV of HCC

Year	Cash flow	PVIF @ 5.5%	PV
	A	B	C =A x B
0	-600000	1.0000	-600000
1	-50000	0.9479	-47393
2	-50000	0.8985	-44923
3	-50000	0.8516	-42581
4	-50000	0.8072	-40361
5	-50000	0.7651	-38257
PV of cash flow	-813514

Thus NPV of HCC = -813414 $

Statement showing NPV of LCC

Year	Cash flow	PVIF @ 5.5%	PV
	A	B	C =A x B
0	-110000	1.0000	-110000
1	-170000	0.9479	-161137
2	-170000	0.8985	-152737
3	-170000	0.8516	-144774
4	-170000	0.8072	-137227
5	-170000	0.7651	-130073
PV of cash flow	-835948

Thus NPV of LCC = -835948 $

Thus Ans) III. 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) V. 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 cash flow are negative NPV can not be 0

c)

Statement showing NPV of HCC

Year	Cash flow	PVIF @ 11%	PV
	A	B	C =A x B
0	-600000	1.0000	-600000
1	-50000	0.9009	-45045
2	-50000	0.8116	-40581
3	-50000	0.7312	-36560
4	-50000	0.6587	-32937
5	-50000	0.5935	-29673
PV of cash flow	-784795

Thus NPV of HCC = -784795 $

Statement showing LCC

Year	Cash flow	PVIF @ 11%	PV
	A	B	C =A x B
0	-110000	1.0000	-110000
1	-170000	0.9009	-153153
2	-170000	0.8116	-137976
3	-170000	0.7312	-124303
4	-170000	0.6587	-111984
5	-170000	0.5935	-100887
PV of cash flow	-738302

Thus NPV of LCC = -738302 $

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

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