In: Finance
Kim Inc. must install a new air conditioning unit in its main
plant. Kim must install...
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 7.5%.
HCC |
-$600,000 |
-$50,000 |
-$50,000 |
-$50,000 |
-$50,000 |
-$50,000 |
LCC |
-$100,000 |
-$175,000 |
-$175,000 |
-$175,000 |
-$175,000 |
-$175,000 |
A.
Which unit would you recommend?
- 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.
- 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.
- 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.
- 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.
- Since all of the cash flows are negative, the NPV's cannot be
calculated and an alternative method must be employed.
B.
If Kim's controller wanted to know the IRRs of the two projects,
what would you tell him?
- There are multiple IRR's for each project.
- The IRR of each project is negative and therefore not useful
for decision-making.
- 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.
- The IRR cannot be calculated because the cash flows are in the
form of an annuity.
- The IRR of each project will be positive at a lower WACC.
C.
If the WACC rose to 15% would this affect your
recommendation?
- When the WACC increases to 15%, the NPV of costs are now lower
for HCC than LCC.
- When the WACC increases to 15%, the IRR for LCC is greater than
the IRR for HCC, LCC would be chosen.
- When the WACC increases to 15%, the IRR for HCC is greater than
the IRR for LCC, HCC would be chosen.
- 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.
- When the WACC increases to 15%, the NPV of costs are now lower
for LCC than HCC.
D.
Why do you think this result occurred?
- The reason is that when you discount at a higher rate you are
making negative CFs smaller thus improving the NPV.
- The reason is that when you discount at a higher rate you are
making negative CFs higher thus improving the IRR.
- The reason is that when you discount at a higher rate you are
making negative CFs higher thus improving the NPV.
- The reason is that when you discount at a higher rate you are
making negative CFs higher and this lowers the NPV.
- The reason is that when you discount at a higher rate you are
making negative CFs smaller and this lowers the NPV.