Question

Respond to the following:

1. Parkallen Inc. has identified the following two mutually exclusive projects:

   Year	Cash Flow (A)	Cash Flow (B)
   0	-$29,000	-$29,000
   1	14,400	4,300
   2	12,300	9,800
   3	9,200	15,200
   4	5,100	16,800

   1. What is the IRR for each of these projects? Using the IRR decision rule, which project should the company accept? Is this decision necessarily correct?

   2. If the required return is 11%, what is the NPV for each of these projects? Which project will the company choose if it applies the NPV decision rule?

   3. Over what range of discount rates would the company choose Project A? What range would cause the company to choose Project B? At what discount rate would the company be indifferent between these two projects? Explain.

   4. What is the payback period for each of these projects? Which project will the company choose if it applies the payback period decision rule?

   5. If the required return is 11%, what is the profitability index for each of these projects? Which project will the company choose if it applies the profitability index decision rule?

2. We believe we can sell 90,000 home security devices per year at $150 per piece. The variable cost is $130 to manufacture. Fixed production costs run $215,000 per year. The necessary equipment costs $785,000 to buy and would be depreciated at a 25% CCA rate. The equipment would have a zero salvage value after the 5-year life of the project. We need to invest $140,000 in net working capital up front; no additional net working capital investment is necessary. The discount rate is 19%, and the tax rate is 35%. What do you think of the proposal?

3. Explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.

4. Refer to the observed capital structures given in Table 16.7 from Section 16.9: Observed Capital Structures of the textbook. What do you notice about the types of industries with respect to their average debt/equity ratios? Are certain types of industries more likely to be highly leveraged than others? What are some possible reasons for this observed segmentation? Do the operating results and tax history of the firms play a role? How about their future earnings prospects? Explain.

5. A project has the following estimated data: price = $54 per unit; variable costs = $36 per unit; fixed costs = $19,300; required return = 12%; initial investment = $26,800; life = 4 years. Ignoring the effect of taxes, what is the accounting break-even quantity? What is the cash break-even quantity? What is the financial break-even quantity? What is the degree of operating leverage at the financial break-even level of output? (20 marks

Answer 1

Using the IRR decision rule, the IRR of project A is higher than that of project B. Hence, the company should accept project A only based on the IRR. This decision is not necessarily correct and one cannot make an investment decision just based on the IRR. There are various other factors which needs to be taken into consideration while making the investment decision like NPV, Price earnings ratio, price to book value ratio, price to sales ratio, etc.

Based on just the NPV decision rule, the company should accept project B as the NPV is higher in this project as compared to project A.

To view the NPV and IRR of both the project and how it was calculated,please view the below snapshot of Excel: