ASSIGNMENT VII

8. Diaz Camera Company is considering two investments, both of which cost $10,000. The cash flows are as follows:

a.

Which of the two projects should be chosen based on the payback method?

Payback period is the number of years in which the initial investment is recouped. Payback for Project A Project A Year

Cash flow (10,000) 6,000 4,000 3,000 3000

Cumulative cash flow (10,000) (4,000) 0 3,000

0 1 2 3

2 years The complete 10,000 investment is recovered in 2 years (6,000+4,000) Payback for Project B Project B Year

Cash flow (10,000) 5,000 3,000 8,000 6000

Cumulative cash flow (10,000) (5,000) (2,000) 6,000

0 1 2 3

2.25 years The complete 10,000 investment is recovered in 2.25 years (5,000+3,000+(8,000/4)) Project A must be selected since it has a smaller payback period. b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

NPV for Project A =

Year

Cash flow

Discount factor @ 10% 1 0.909091 0.826446 0.751315 NPV=

Discounted cash flow=

0 1 2 3

(10,000) 6,000 4,000 3,000

-10,000 5,455 3,306 2,254 1,015

=10000*1 =6000*0.909091 =4000*0.826446 =3000*0.751315

$1,015.00 NPV for Project B

Year

Cash flow

Discount factor @ 10% 1 0.909091 0.826446 0.751315 NPV=

Discounted cash flow=

0 1 2 3

(10,000) 5,000 3,000 8,000

-10,000 4,545 2,479 6,011 3,035

=10000*1 =5000*0.909091 =3000*0.826446 =8000*0.751315

$3,035. Project B must be selected since it has a larger NPV

c.

Should a firm normally have more confidence in answer a or answer b?

The firm should have more confidence in Answer (b) since the payback period has a lot of cons. Payback method does not consider the time value of money and thus leads to incorrect decisions.

16. The Pan American Bottling Co. is considering the purchase of a new machine that would increase the speed of bottling and save money. The net cost of this machine is $45,000. The annual cash flows have the following projections:

a.

If the cost of capital is 10 percent, what is the net present value of selecting a new machine?

Year cost 1 2 3 4 5

Cash Flows 45,000 15,000 20,000 25,000 10,000 5,000

From the table, PV of cash flows = $58,882.90, and its cost is $45,000 now. Then NPV= $58,882.90-45,000= 13,882.90

b.

What is the internal rate of return?

$13,882.90 / 58,882.90 * 100 IRR 23%

c.

Should the project be accepted? Why?

Yes. NPV is greater than 0 and IRR is greater than the cost of capital (10%)

17. You are asked to evaluate the following two projects for the Norton Corporation. Using the net present value method, combined with the profitability index approach described in footnote 2 of this chapter, which project would you select? Use a discount rate of 10 percent.

Year 0 1 2 3 4

Project X Cash Flows -10,000 5,000 3,000 4,000 3,600

Year 0 1 2 3 4

Project Y Cash Flows -30,000 15,000 8,000 9,000 11,000

NPV of Project X NPV of Project Y PI of Project X PI of Project Y

2,488.90 4,522.92 0.25 0.15

NPV of Project Y is higher than that of Project X. However, PI of X is higher than that of Y. Thus, I'll select Project X.

For the formulas I used excel to do my calculations.