Problem No. 1 (20%)
The National Capital District Commission (NCDC) is considering the purchase of a site for a new landfill. The purchase price for the site, including the related preparatory work, will cost K322,080. The landfill would be useable for 10 years. NCDC hired a consultant, who estimated that the new landfill would cost less to operate (savings) of K48,000 per year than the current landfill. The current landfill will also last 10 more years. For a landfill project, NCDC can borrow money from the national government at a subsidized rate. NCDC’s required rate of return is only 6 per cent for this project. It does not pay any income taxes.
Required:
a. What is the payback period for this investment?
b. Calculate the net present value of the new landfill. Should NCDC approve the project?
c. Calculate the internal rate of return for the landfill. Should NCDC approve the project?
Problem No. 2 (20%)
Diane Dennison is a financial analyst working for a large chain of discount retail stores. Her company is looking at the possibility of replacing the existing fluorescent lights in all of its stores with LED lights. The main advantage of making this switch is that the LED lights are much more efficient and will cost less to operate. In addition, the LED lights last much longer and will have to be replaced after ten years, whereas the existing lights have to be replaced after five years. Of course, making this change will require a large investment to purchase new LED lights and to pay for the labor of switching out tens of thousands of bulbs. Diane plans to use a 10-year horizon to analyze this proposal, figuring that changes to lighting technology will eventually make this investment obsolete.
Diane’s friend and coworker, David, has analyzed another energy-saving investment opportunity that involves replacing outdoor lighting with solar-powered fixtures in a few of the company’s stores. David also used a 10-year horizon to conduct his analysis.
Cash flow forecasts for each project appear below. The company uses a 10% discount rate to analyze capital budgeting proposals.
Year LED project Solar project
0 -$4,200,000 -$500,000
1 700,000 60,000
2 700,000 60,000
3 700,000 60,000
4 700,000 60,000
5 1,000,000 60,000
6 700,000 60,000
7 700,000 60,000
8 700,000 60,000
9 700,000 60,000
10 700,000 60,000
Required:
a. What is the NPV of each investment? Which investment (if either) should the company undertake?
b. David approaches Diane for a favor. David says that the solar lighting project is a pet project of his boss, and David really wants to get the project approved to curry favor with his boss. He suggests to Diane that they roll their two projects into a single proposal. The cash flows for this combined project would simply equal the sum of the two individual projects. Calculate the NPV of the combined project? Does it appear to be worth doing? Would you recommend investing in the combined project?
c. What is the ethical issue that Diane faces? Is any harm done if she does the favor for David as he asks?