Question

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 are 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 higher operating costs because it uses more electricity. The costs of the units are shown here. Kim's WACC is 6%.

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1

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3

4

5

HCC	-$600,000	-$45,000	-$45,000	-$45,000	-$45,000	-$45,000
LCC	-$100,000	-$180,000	-$180,000	-$180,000	-$180,000	-$180,000

1. Which unit would you recommend?
   1. Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.
   2. 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.
   3. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since HCC's NPV of costs is lower than LCC's, HCC would be chosen.
   4. 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 IRR.
   5. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since LCC's NPV of costs is lower than HCC's, LCC would be chosen.

B. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?

1. The IRR cannot be calculated because the cash flows are in the form of an annuity.
2. The IRR of each project will be positive at a lower WACC.
3. There are multiple IRR's for each project.
4. The IRR of each project is negative and therefore not useful for decision-making.
5. The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.

C. If the WACC rose to 12% would this affect your recommendation?

1. When the WACC increases to 12%, the NPV of costs are now lower for LCC than HCC.
2. When the WACC increases to 12%, the NPV of costs are now lower for HCC than LCC.
3. When the WACC increases to 12%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.
4. When the WACC increases to 12%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.
5. 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.

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 and this lowers the NPV.
2. The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.
3. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.
4. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.
5. The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.

Answer 1

Which unit would you recommend?
NPV of HCC:
=-600000-45000/6%*(1-1/1.06^5)=-789556.370350457
NPV of LCC:
=-100000-180000/6%*(1-1/1.06^5)=-858225.481401829

Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since HCC's NPV of costs is lower than LCC's, HCC would be chosen.

If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?
The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.

If the WACC rose to 12% would this affect your recommendation?
NPV of HCC:
=-600000-45000/12%*(1-1/1.12^5)=-762214.929105525
NPV of LCC:
=-100000-180000/12%*(1-1/1.12^5)=-748859.716422101

When the WACC increases to 12%, the NPV of costs are now lower for LCC than HCC.

Explain your answer and the reason this result occurred.
The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.