Questions -
Q1. Global Auto wants to choose the better of two mutually exclusive projects for expanding the firm's production capacity. The relevant cash flows for the projects are shown in the following table. The firm's cost of capital is 15%.
|
Initial Cash Outslow (CF0):
|
Project A
|
Project B
|
|
$650,000
|
$358,000
|
|
Year (t)
|
Cash Inflows (CFt)
|
|
1
|
$100,000
|
$154,000
|
|
2
|
122,000
|
122,000
|
|
3
|
175,000
|
150,000
|
|
4
|
289,000
|
100,000
|
|
5
|
275,000
|
55,000
|
a. Calculate the IRR for each of the projects. Which project is preferred, based on the IRR?
b. Calculate the payback for each of the projects. Which project is preferred, based on the payback?
Q2. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $12 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 50% will come from customers who switch to the new, healthier pizza instead of buying the original version. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza?
Q3. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store.
Which of the following should be included as part of the incremental earnings for the proposed new retail store?
a. The cost of the land where the store will be located.
b. The cost of demolishing the abandoned warehouse and clearing the lot.
c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead.
d. The $10,000 in market research spent to evaluate customer demand.
e. Construction costs for the new store.
f. The value of the land if it can be sold.
g. Interest expense on the debt borrowed to pay the construction costs.
Q4. Project ABC has an initial cost of $1,000 and generates cash inflow of $2,000 at the end of year 1. Project QRS has an initial cost of $10,000 and has annual cash inflows of $4,400, $4,840, and $5,324 in year 1-3. Assuming a 10% discount rate, calculate the net present value and profitability index for both projects. Which project is better in terms of NPV? Which project is better in terms of Profitability Index (PI)?
Q5. A study done by Dr. Graham and Harvey found that a sizeable minority of firms (25%) in their study do not use the NPY rule. In addition, about 50% of firms surveyed used the payback rule. Also, most firms use both the NPV and the IRR rules. Why do firms use rules other than NPV since they can lead to erroneous decisions?
Q6. Gina Corp. runs a manufacturing business. For this fiscal year, it estimates its net cash flow will be $250,000. Due to the competition, the company expects its net cash flows will decrease at 3% per year in perpetuity. The appropriate discount rate of the company is 5%. All net cash flows are received at year-end. What is the present value of the cash flows from the company's operations?
Q7. The management of Kimco is evaluating the possibility of replacing their large mainframe computer with a modern network system that requires much less office space. The network would cost $500,000 (including installation costs) and would save $125,000 per year in net cash flows (accounting for taxes and depreciation) over the next five years due to efficiency gains. The mainframe has a remaining book value of $50,000 and would be immediately donated to a charity for the tax benefit. Kimco's discount rate is 10% and its tax rate is 40%. On the basis of NPV, should management install the network system?