Question

Follow the format shown in Exhibit 12B.1 and Exhibit 12B.2 as you complete the requirements below.

Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows.

1. Cuenca Company is considering the purchase of new equipment that will speed up the process for producing flash drives. The equipment will cost $7,200,000 and have a life of 5 years with no expected salvage value. The expected cash flows associated with the project follow:

   Year		Cash Revenues		Cash Expenses
   1		$8,000,000		$6,000,000
   2		8,000,000		6,000,000
   3		8,000,000		6,000,000
   4		8,000,000		6,000,000
   5		8,000,000		6,000,000

2. Kathy Shorts is evaluating an investment in an information system that will save $240,000 per year. She estimates that the system will last 10 years. The system will cost $1,248,000. Her company's cost of capital is 10%.
3. Elmo Enterprises just announced that a new plant would be built in Helper, Utah. Elmo told its stockholders that the plant has an expected life of 15 years and an expected IRR equal to 25%. The cost of building the plant is expected to be $2,880,000.

Required:

1. Calculate the IRR for Cuenca Company. The company's cost of capital is 16%. Round your answer to the nearest percent.
%

Should the new equipment be purchased?
No

2. Calculate Kathy Short's IRR. Round your answer to the nearest percent.
%

Should she acquire the new system?
Yes

3. What should be Elmo Enterprises' expected annual cash flow from the plant? Round your answer to the nearest dollar.
$

Feedback

Answer 1

1	Cuenca Case :
	Year	0	1	2	3	4	5
	Equipment Cost ($)	72,00,000	-	-	-	-	-
	Revenue ($)	-	80,00,000	80,00,000	80,00,000	80,00,000	80,00,000
	Expenses ($)	-	60,00,000	60,00,000	60,00,000	60,00,000	60,00,000
	Net Cash Flows (Revenue - Expenses - Cost of Equipment) ($)	-72,00,000	20,00,000	20,00,000	20,00,000	20,00,000	20,00,000
	IRR (using Excel Function)	12.05%
	Decision: Since the IRR of New investment is less than the cost of capital (16%) it should not be pursued
2	Kathy Shorts:
	The firm can save $ 240,000 per annum for 10 years by investing $ 12,48,000. This is like an annuity stream for 10 years and the IRR will be the rate of interest which will equate the present value of the annuity cash flows to current investment value. If we denote the IRR rate as r - we can use the present value of the annuity formula:
	1248000 = 240000 * [1 - (1+r)-10]/r or r = 14.08%
	Decision: Since IRR is 14.08% and it is higher than Kathy Shorts Cost of Capital at 10%, they should invest in this project.
3	Elmo Enterprises case:
	We will again use the annuity present value formula. The initial investment is given at 2,880,000.00 and IRR is 25% and Tenure is 15 years. If we denote the annual cash flows as X; then we have:
	2880000 = X * [1 - (1+25%)-15]/25% or X = 746256.57 - rounded it will be = $ 7,46,257