Question

Problem 11-14
Choosing mandatory projects on the basis of least cost

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%.

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5

HCC	-$590,000	-$45,000	-$45,000	-$45,000	-$45,000	-$45,000
LCC	-$100,000	-$175,000	-$175,000	-$175,000	-$175,000	-$175,000

1.Which unit would you recommend? (select multiple choice answer)

a.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.

b.Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.

c.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.

d.Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since LCC's PV of costs is lower than HCC's, LCC would be chosen.

e.Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since HCC's PV of costs is lower than LCC's, HCC would be chosen.

2.If Kim's controller wanted to know the IRRs of the two projects, what would you tell him? (select multiple choice answer)

a.The IRR of each project will be positive at a lower WACC.

b.There are multiple IRR's for each project.

c.The IRR of each project is negative and therefore not useful for decision-making.

d.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.

e.The IRR cannot be calculated because the cash flows are in the form of an annuity.

3.If the WACC rose to 10% would this affect your recommendation? (select multiple choice answer)

a.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.

b.When the WACC increases to 10%, the PV of costs are now lower for LCC than HCC.

c.When the WACC increases to 10%, the PV of costs are now lower for HCC than LCC.

d.When the WACC increases to 10%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.

e.When the WACC increases to 10%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.

4.Explain your answer and why this result occurred. (select multiple choice answer)

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

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

c.The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.

d.The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.

e.The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.

Answer 1

Calculation of present values of cash outflows of HCC and LCC at 5%

Present value of cash outflows of HCC = 590,000 + 45,000 x PVAF(_{5%, 5} )

= 590,000 + 45,000 x 4.329

= 590,000 + 194,805

= $784,805

Present value of cash outflows of LCC = 100,000 + 175,000 x PVAF(_{5%, 5} )

= 100,000 + 175,000 x 4.329

= 100,000 + 757,575

= $857,575

1. The correct option is (e)

Since we are examining cost, the unit chosen would be the one that had the lower present value of costs. Since present value of cost of HCC ($784,805) is lower than present value of cost of LCC ($857,575), hence HCC must be chosen.

2. The correct option is (d)

The IRR of HCC and LCC cannot be calculated since cash flows of both HCC and LCC are having same sign i.e. negative. A change of sign would be needed to calculate IRR. IRR of a project cannot be calculated just on the bais of cash outflows. Cash inflows must be there.

3.

Calculation of present values of cash outflows of HCC and LCC at 10%

Present value of cash outflows of HCC = 590,000 + 45,000 x PVAF(_{10%, 5} )

= 590,000 + 45,000 x 3.791

= 590,000 + 170,595

= $760,595

Present value of cash outflows of LCC = 100,000 + 175,000 x PVAF(_{10%, 5} )

= 100,000 + 175,000 x 3.791

= 100,000 + 663,425

= $763,425

If WACC rises to 10%, it would not affect the recommendation since present value of cost of HCC would be still lower than the present value of cost of LCC.

Hence, the correct option is (c)

4. The correct option is (c)

When discounting is done at a higher rate, Present value of cash outflows falls and thus it improves the NPV. In the given question, when discounting was done at 5%, present value of cash outflows of HCC and LCC was $784,805 and $857,575 respectively. When discounting was done at 10%, present value of cash outflows of HCC and LCC was $760,595 and $763,425 respectively. Hence, dicounting at higher rate reduced the present value of cash outflows. Even at higher WACC, HCC must be chosen since its present value of cash outflows is still lower as compared to present value of cash outflows of LCC.