Consider the following projects and assume an opportunity cost of capital of 12%.

Cash Flows

Project C0 C1 C2

A -20,000 45,000 15,000

B -10,000 15,000 30,000

C -10,000 15,000 25,000

a.Calculate the Net Present Value (NPV) of each project. Which is to be preferred and why?

b.If there is a capital constraint in place which limits spending to 10,000, which project or projects should be selected? Support your answer with calculations.

c.Explain how the following should be treated in a net present value calculation of a project: 1.sunk costs; 2.depreciation; 3.non-incremental costs (such as allocated head office costs).

d.Respond briefly to the following comments:

I.Elizabeth Smith says that she likes the internal rate of return (IRR) because she can use it to rank projects without having to specify a discount rate.

II.Elizabeth Smith also says that she likes the payback rule, as long as the minimum payback period is short, the rule makes sure that the company takes no borderline projects. That reduces risk.

e.Briefly discuss the limitations of the CAPM as a method for determining the opportunity cost (discount rate) of a project.