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Study Quest and Problem Bab 11

The document describes three types of capital investment projects: revenue-enhancing, cost-reducing, and mandatory. It also defines mutually exclusive projects as those where a firm can only choose one alternative, such as different machinery that perform the same function. While payback period is easy to calculate and indicates risk, it does not consider the time value of money or cash flows beyond the payback point. The document then provides examples of calculating net present value and equivalent annual cost to analyze investment project alternatives.

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332 views8 pages

Study Quest and Problem Bab 11

The document describes three types of capital investment projects: revenue-enhancing, cost-reducing, and mandatory. It also defines mutually exclusive projects as those where a firm can only choose one alternative, such as different machinery that perform the same function. While payback period is easy to calculate and indicates risk, it does not consider the time value of money or cash flows beyond the payback point. The document then provides examples of calculating net present value and equivalent annual cost to analyze investment project alternatives.

Uploaded by

Vina Deviana
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Study

Questio
ns
Financial Management

11-3: Some firms


categorize projects as
revenue-enhancing,
cost-reducing, and
mandatory. Describe
what this means.

Answer:
There are three types of capital
investments project:
1. Revenue enhancing Investments
(for example, entering a new market)
2. Cost-reduction investments (for
example, installing a more efficient
equipment)
3. Mandatory investments that are a
result of government mandate (for
example, installing mandatory safety

11-6: What does it mean to say that


two or more investment projects
are mutually exclusive?

Answers:
Following are two situations where firm is
faced with mutually exclusive projects:
1. Substitutes Where firm is trying to pick
between alternatives that perform the same
function. For example, a new machinery for
the new project. While there might be many
good machines, the firm needs only one.
2. Firm Constraints Firm may face
constraints such as limited managerial time
or limited financial capital that may limit its
ability to invest in all the positive NPV
opportunities.

11-7: What are the limitations of the


payback period as an investment
decision criterion? What are its
advantages? Why do you think it is used
so frequently?

Answers:
Limitations:
1. Does not account for the time value
of money
2. Does not consider cash flows
beyond the payback period
3. Utilizes an arbitrary cutoff criterion
Advantages:
- Easy to understand and calculate
- An indication of risk (how long it
takes to recover the investment)

Study
Proble
ms
Financial Management

11-8:
East Coast Television is considering a project with an
initial outlay of $X (you will have to determine this
amount). It is expected that the project will produce a
positive cash flow of $50,000 a year at the end of each
year for the next 15 years. The appropriate discount
rate for this project is 10%. If the project has a 14%
internal rate of return, what is the projects net present
value?

IRR: at a 14% discount rate, the project has a zero NPV. at 14%,
the present value of the 15, $50,000 cash flows equals the initial
outlay. We can therefore solve for this outlay as follows:
$50,000 $50,000
$50,000 $50,000

...

(1.14)1
(1.14)2
(1.14)14
(1.14)15
$50,000 $50,000
$50,000 $50,000
$X

...

(1.14)1
(1.14)2
(1.14)14
(1.14)15
$307,108.
0 $ X

Now that we know the initial cash flow, we can find the NPV of
$50,000 $50,000
$50,000 $50,000
the stream at 10%:
NPV $307,108

...

(1.10)1

(1.10)2

(1.10)14

(1.10)15

$73,196.

The NPV is positive because the 10% discount rate we used is


less than the streams IRR.

11-4:
Barry Boswell is a financial analyst for Dossman Metal Works, Inc.,
and he is analyzing two alternative configurations for the firms new
plasma cutter shop. The two alternatives that are denoted A and B
below perform the same task and although they both cost $80,000
to purchase and install, they offer very different cash flows.
Alternative A has a useful life of 7 years while Alternative B will only
last for 3 years. The after-tax costs for the two projects are as
follows:
Year

Alternative A

Alternative B

$ (80,000)

$ (80,000)

(20,000)

(6,000)

(20,000)

(6,000)

(20,000)

(6,000)

(20,000)

(20,000)

(20,000)

(20,000)

a. Calculate each projects equivalent annual cost (EAC) given a


10% discount rate
b. Which of the alternatives do you think Barry should select? Why?

Answers:
A. At a 10% discount rate, the PV cost of these
alternatives are:
PVA = (80,000) + (20,000)/ (1.1)1 + (20,000)/
(1.1)2 +.. (20,000)/ (1.1)7
PVA = ($ 177,368)
EAC is the effective annual cost and is found by
dividing the PV costs of the project by the
annuity factor for the discount rate and term of
the project, as follows:
EACA = ($ 177,368) / 4.8684
EACA = ($ 36,432)
PVB = (80,000) + (6000)/ (1.1)1 + (6000)/ (1.1)2 +
(6000)/(1.1)3
PVB = ($94,921)
EACB = ($94,921) / 2.4869
EACB = ($38,168)
B. Even though alternative B has lower annual cost cash
flows, the project has a very short useful life, and thus has a
higher EAC than alternative A (-$38,168 versus -$36,432).
Accordingly, alternative A should be selected, since it
results in a lower equivalent annual cost to operate.

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