Assignment
I. Your firm spends $522,000 per year in regular maintenance of its equipment. Due to the economic downturn, the firm considers forgoing these maintenance expenses for the next years. If it does so, it expects it will need to spend $2.1 million in year 4 replacing failed equipment.
i. What is the IRR of the decision to forgo maintenance of the equipment?
ii. Does the IRR rule work for this decision?
iii. For what costs of capital (COC) is forgoing maintenance a good decision?
II. Your firm has been hired to develop new software for the university's class registration system. Under the contract, you will receive $503,000 as an upfront payment. You expect the development costs to be $457,000 per year for the next 3 years. Once the new system is in place, you will receive a final payment of $908,000 from the university 4 years from now.
i. What are the IRRs of this opportunity?
(Hint: model which tests the NPV at 1% intervals from 1% to 40%. Then zero in on the rates at which the NPV changes signs.)
ii. If your cost of capital is 10%, is the opportunity attractive? Suppose you are able to renegotiate the terms of the contract so that your final payment in year 4 will be $1.3 million. What is the IRR of the opportunity now?
iii. Is it attractive at the new terms?
III. You work for an outdoor play structure manufacturing company and are trying to decide between the following two projects:
|
|
?Year-End Cash Flows? ($ thousands)
|
|
Project
|
0
|
1
|
2
|
IRR
|
|
Playhouse? (minor project)
|
-30
|
19
|
20
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19.2?%
|
|
Fort? (major project)
|
-78
|
40
|
51
|
10.5?%
|
You can undertake only one project. If your cost of capital is 7%, use the incremental IRR rule to make the correct decision.
IV. You are considering a safe investment opportunity that requires a $1,330 investment today, and will pay $840 two years from now and another $580 five years from now.
i. What is the IRR of this investment?
ii. If you are choosing between this investment and putting your money in a safe bank account that pays an EAR of 5% per year for any horizon, can you make the decision by simply comparing this EAR with the IRR of the investment? Explain.