Question

OOSING MANDATORY PROJECTS ON THE BASIS OF LEAST COST m 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 ould 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 love erating 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 ACC is 6.5%. 1CC -$600,000 $45,000 -$45,000 $45,000 -$45,000 -$45,000 -$110,000 -$175,000 $175,000 $175,000 -$175,000 $175,000 a. Which unit would you recommend? 1. 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. II. 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. III. Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed. IV. 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. V. 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. -Select- b. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him? 1. The IRR of each project is negative and therefore not useful for decision-making. II. 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 III. The IRR cannot be calculated because the cash flows are in the form of an annuity IV. The IRR of each project will be positive at a lower WACC. V. There are multiple IRR's for each project.

Answer 1

Which unit would you recommend?
NPV of HCC:
=-600000-45000/6.5%*(1-1/1.065^5)=-787005.5747

NPV of LCC:
=-110000-175000/6.5%*(1-1/1.065^5)=-837243.9017

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 13% would this affect your recommendation?
NPV of HCC:
=-600000-45000/13%*(1-1/1.13^5)=-758275.4068

NPV of LCC:
=-110000-175000/13%*(1-1/1.13^5)=-725515.4708

When the WACC increases to 13%, 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.