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Unformatted text preview: . 124 d. Accept Project B. Since the Projects are mutually exclusive, choose the Project with the highest PI, while taking into account the scale of the Project. Because Projects A and C have the same initial investment, the problem of scale does not arise when comparing the profitability indices. Based on the profitability index rule, Project C can be eliminated because its PI is less than the PI of Project A. Because of the problem of scale, we cannot compare the PIs of Projects A and B. However, we can calculate the PI of the incremental cash flows of the two projects, which are: Project B–A C0 –$200,000 C1 $120,000 C2 $120,000 When calculating incremental cash flows, remember to subtract the cash flows of the project with the smaller initial cash outflow from those of the project with the larger initial cash outflow. This procedure insures that the incremental initial cash outflow will be negative. The incremental PI calculation is: PI(B – A) = [$120,000 / 1.12 + $120,000 / 1.122] / $200,000 PI(B – A) = 1.014 The company should accept Project B since the PI of the incremental cash flows is greater than one. e. Remember that the NPV is additive across projects. Since we can spend $600,000, we could take two of the projects. In this case, we should take the two projects with the highest NPVs, which are Project B and Project A. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the initial investment. Dry Prepeg: Cumulative cash flows Year 1 = $900,000 = $900,000 Cumulative cash flows Year 2 = $900,000 + 800,000 = $1,700,000 Payback period = 1 + ($500,000/$800,000) = 1.63 years Solvent Prepeg: Cumulative cash flows Year 1 = $300,000 = $300,000 Cumulative cash flows Year 2 = $300,000 + 500,000 = $800,000 Payback period = 1 + ($300,000/$500,000) = 1.60 years Since the solvent prepeg has a shorter payback period than the dry prepeg, the company should choose the solvent prepeg. Remember the payback period does not necessarily rank projects correctly. 18. a. 125 b. The NPV of each project is: NPVDry prepeg = –$1,400,000 + $900,000 / 1.10 + $800,000 / 1.102 + $700,000 / 1.103 NPVDry prepeg = $605,259.20 NPVG4 = –$600,000 + $300,000 / 1.10 + $500,000 / 1.102 + $400,000 / 1.103 NPVG4 = $386,476.33 The NPV criteria implies accepting the dry prepeg because it has the highest NPV. c. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR of the dry prepeg is: 0 = –$1,400,000 + $900,000 / (1 + IRR) + $800,000 / (1 + IRR)2 + $7,000,000 / (1 + IRR)3 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRRDry prepeg = 34.45% And the IRR of the solvent prepeg is: 0 = –$600,000 + $300,000 / (1 + IRR) + $500,000 / (1 + IRR)2 + $400,000 / (1 + IRR)3 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRRSolvent prepeg = 41.87% The IRR criteria implies accepting the solvent prepeg because it has the highest IRR. Remember the IRR does not necessarily rank projects correctly. d. Incremental IRR analysis is necessary. The solvent prepeg has a higher IRR, but is relatively smaller in terms of investment and NPV. In calculating the incremental cash flows, we subtract the cash flows from the project with the smaller initial investment from the cash flows of the project with the large initial investment, so the incremental cash flows are: Dry prepeg Solvent prepeg Dry prepeg – Solvent prepeg Year 0 –$1,400,000 –600,000 –$800,000 Year 1 $900,000 300,000 $600,000 Year 2 $800,000 500,000 $300,000 Year 3 $700,000 400,000 $300,000 Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is: 0 = –$800,000 + $600,000 / (1 + IRR) + $300,000 / (1 + IRR)2 + $300,000 / (1 + IRR)3 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: Incremental IRR = 27.49% 126 For investingtype projects, we accept the larger project when the incremental IRR is greater than the discount rate. Since the incremental IRR, 27.49%, is greater than the required rate of return of 10 percent, we choose the dry prepeg. Note that this is the choice when evaluating only the IRR of each project. The IRR decision rule is flawed because there is a scale problem. That is, the dry prepeg has a greater initial investment than does the solvent prepeg. This problem is corrected by calculating the IRR of the incremental cash flows, or by evaluating the NPV of each project. 19. a. The NPV of each project is: NPVNP30 = –$450,000 + $160,000{[1 – (1/1.15)5 ] / .15 } NPVNP30 = $86,344.82 NPVNX20 = –$200,000 + $80,000 / 1.15 + $92,000 / 1.152 + $105,800 / 1.153 + $121,670 / 1.154 + $139,921 / 1.155 NPVNX20 = $147,826.34 The NPV criteria implies accepting the NX20. b. The IRR is the interest rate that makes the NPV of the project equal to zero, so the IRR of each project is: NP30: 0 = –$450,000 + $160,000({1 – [1/(1 + IRR)5 ]} / IRR) Using a spreadsheet, financial calculator, or trial and error to find...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of TexasTyler.
 Spring '10
 eshmalwi
 Finance, Corporate Finance

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