Investment Decision Rules and Other Problems

Problem 1: You as the financial manager have 4 projects to evaluate:

Project A has an initial investment of $100 million, and cash flows of $35 million a year for 5 years.

Project B has an initial investment of $40 million, and cash flows of $5 million, $2 million, $17 million, $30 million and $50 million.

Project C has an initial investment of $70 million, and cash flows of $16 million for the first 3 years, and then $90 million.

Project D has an initial investment of $200 million, and cash flows of $50 million, $70 million, $60 million, $40 million and $40 million.

--> If the cost of capital is 12%, which projects would you choose if you have no capital constraints based on the NPV rule?

What is the IRR for each of the projects? Does your decision rule based on the IRR lead to the same conclusion as the NPV rule?

Would your answer change if the cost of capital is 9%? Explain why it changed?

Compute the payback period for each of the projects. Would you accept any projects if you only had 3 years or less to recover your investment? Why is the payback period not necessarily a good rule based specifically on these projects?

Assuming the cost of capital is 9%, what project would you accept if they are mutually exclusive?

Calculate the Profitability index for the projects. Assuming the cost of capital is 9%, which project(s) would you accept if you have only $120 million of capital to invest?

Problem 2: Your company is considering 2 service contracts. Plan A has an initial cost of $10000 with an additional cost of $900 per year for 5 years. Plan B has an initial cost of $7000 with an additional cost of $3000 per year for 3 years. Which contract should your company take if the cost of capital is 9%? Calculate the NPV and Equivalent Annual Annuity (EAA) for each plan.