CHOOSING MANDATORY PROJECTS ON THE BASIS OF LEAST COST 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 we 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 her operating costs because it uses more electricity. The costs of the units are shown here. Kim's WACC is 5 0 1 3 5 HCC ICC - $610.000 -$55,000 -$55,000 -$55,000 -$55,000 $55,000 - $100.000 $180,000 $180,000 -$180,000 -$180,000 -$180,000 a. Which unit would you recommend 1. 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 11. 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 RR 111. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since ICC's NPV of costs is lower than HCC, LCC would be chosen IV. Since we are examining costs, the unit chosen would be the one that had the lower NPV of Cone HOC's NPV of costs is lower than LCC's, HCC would be chosen V Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be loved b. If Kim's controller wanted to know the IRR of the two projects, whit would you tell? 1. There are multiples for each project II. The IRR of each project is negative and therefore not useful for decision-making. III. The IRR cannot be calculated because the cash flows are all one sign. A change of skin would be needed in order to calculate the TRR IV. The IRR cannot be calculated because the cash flows are in the form of an annuity V. The IRR of each project will be positive at a lower WACC c. If the WACC rose to 10% would this affect your recommendation? 1. When the WACC increases to 10%, the NPV of costs are now lower for HCC than LCC II. When the WACC increases to 10%, the TRR for LCC is greater than the tre for HOC, LCC would be chosen TIL. When the WACC increases to 10%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen IV. 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, V. When the WACC increases to 10%, the NPV of costs are now lower for LCC than HCC. -Select- b. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him? I. There are multiple IRR's for each project II. The IRR of each project is negative and therefore not useful for decision-making. III. The IRR cannot be calculated because the cash flows are all one sign. A change of sion would be needed in order to calculate the IRR IV. The IRR cannot be calculated because the cash flows are in the form of an annuity V. The IRR of each project will be positive at a lower WACC. c. If the WACC rose to 10% would this affect your recommendation? 1. When the WACC increases to 10%, the NPV of costs are now lower for HOC than LCC. 11. When the WACC increases to 10%, the TRR for LCC is greater than the IRR for HOC, LCC would be chosen. III. When the WACC increases to 10%, the IRR for HOC is greater than the IRR for LCC, HCC would be chosen IV. 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 V. When the WACC increases to 10%, the NPV of costs are now lower for LCC than HOC. Select 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 thus improving the NPV. 11. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR. III. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV. IV. The reason is that when you discount at a higher rate you are making negative CFs higher and this towers the NPV. V. The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV. -Select
