Ch 11:End-of-Chapter Problems - The Basics of Capital Budgeting 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% 1 2 3 HCC LCC -$590,000 -$45,000 -$45,000 -$45,000 -$45,000 -$45,000 -$110,000 -$170,000 -$170,000 -$170,000 -$170,000 -$170,000 a. Which unit would you recommend? 1. Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed 11. Since all of the cash fows are give, the NPV's will be negative and we do not accept any project that has a negative NPV. III. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since HOC NPV of costs is lower than LCC's, HCC would be chosen IV. 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. V. 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 b. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him? 1. The IRR cannot be calculated because the cash flows are in the form of an annuty. II. The IRR of each project will be postive at a lower WACC. II. There are multiple IRR's for each project TV. The IRR of each project is negative and therefore not useful for decision-making. V. The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be reeded in order to calculate the IRR. c. If the WACC rose to 15% would this affect your recommendation? I When the WACC increases to 15%, the NPV of costs are now lower for LCC than HOC II. When the WACC increases to 15%, the NPV of costs are now lower for HCC than LCC. II. When the WACC increases to 15%, the TRR for CC greater than the IRR for HOC, LOC would be chosen IV. When the WACC increases to 15%, the IRR for HCC is greater than the IRR for LOC, 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. Explain your answer and the reason this result occurred. 1. The reason is that when you discount at a higher rate you are making negative CFs smaller and this towers the NPV. II. The reason is that when you discount at a higher rate you are making negative is smaller thus improving the NPV. TIL The reason is that when you discount at a higher rate you are making negative sugherthus improving the IRR. IV. The reason is that when you discount at a higher rate you are making wives higher thus improving the NPV. The reason is that when you discount at a higher rate you are making negative is higher and this lower the NPV