Question

Section 6:

Wally's Water Delivery Company is considering buying a second delivery truck so that it can expand its operations. The company currently has $250,000 in annual sales. The truck will cost $45,000. Wally believes that the second truck will allow his company to increase its cash flows by $25,000 in the first year. The cash flows associated with the new truck are expected to increase by 25% each year (vs. the prior year) for years 2, 3, and 4. Wally uses a 22% cost of capital to evaluate new projects. Wally's assistant just calculated the IRR of the project and came up with a number higher than the company's cost of capital. What does this mean?

Group of answer choices

Wally should reject the project because it does not meet his criteria.

Wally's payback will be in excess of 3 years, therefore he should reject the project.

Wally should raise his cost of capital to equal the IRR, so that he will have an NPV of zero on the project.

The NPV will likely be positive. Wally should probably approve the project.

Tony's Taco Shack is thinking about buying a commercial ice cream machine so that they can sell their famous refried-beans-with-sour-cream-and-picante-sauce-flavored ice cream (topped with guacamole-flavored caramel sauce and crushed tortilla chips). Tony is considering two different machines. Each one is projected to generate different sets of cash flows to the Taco Shack:

Machine A (The Rapido model)

Cost: $40,000. Cash flows: Year 1: $25,000; Year 2: $26,000; Year 3: $31,000

Machine B (The Delicioso model)

Cost: $58,000. Cash flows: Year 1: $16,000; Year 2: $29,000; Year 3: $41,000

Tony's cost of capital is 19%. Calculate the NPV for each machine. Are they both acceptable? Rank them. Which one is the best investment for Tony (based on NPV)?  

Group of answer choices

They are both acceptable. Machine A has a much larger NPV and is the best investment for Tony.

Machine B is the only one that is acceptable. Tony should invest in Machine B.

Neither one is acceptable. They should both be rejected.

Machine A is the only one that is acceptable. Tony should invest in Machine A.

Answer 1

1. (d) The NPV will likely be positive. Wally should probably approve the project.

Explanation:

IRR refers to the rate of return provided by a specific project and cost of capital refers to the rate of return required by the company. If the IRR of a project is higher than the company's cost of capital, it implies that the project is viable for the company and NPV of the project will be positive.

2. (a) They are both acceptable. Machine A has a much larger NPV and is the best investment for Tony.

Explanation: