# ACT 5733 Spring 2015 HW 2 Solutions

Spring 2015

HW #2 KEY

Question #1

Consider the following potential investment, which has the same risk as the firm’s other projects: Time

CF

Cumulative

PV

0

($175,000)

($175,000)

($175,000)

1

$46,000

($129,000)

$41,818

2

$50,000

($79,000)

$41,322

3

$53,000

($26,000)

$39,820

4

$54,000

$28,000

$36,883

5

$55,000

$83,000

$34,151

Discount rate

10%

$18,994

Payback

3.49

years

NPV

$18,994

IRR

14.03%

a) What are the investment’s payback period, IRR, and NPV, assuming the firm’s WACC is 10%? SEE TABLE

b) If the firm requires a payback period of less than 4 years, should this project be accepted? Be sure to justify your choice. Yes, since the payback of 3.49 is less than the maximum of 4 years.

c) Based on the IRR and NPV rules, should this project be accepted? Be sure to justify your choice. Yes, since NPV > 0 and IRR > discount rate.

d) Which of the decision rules (payback, NPV, or IRR) do you think is the best rule for a firm to use when evaluating projects? Be sure to justify your choice. NPV is best as it has an objective decision rule, uses all cash flows, is based on cash flows (not income), can incorporate multiple discount rates, and is not biased toward smaller projects. The IRR also has an objective decision rule, uses all cash flows, and is based on cash flows, but it cannot incorporate multiple rates, can be biased toward smaller projects, and sometimes results in multiple answers. Payback is relatively straight forward, but it ignore cash flows occurring after payback is reached and does not have an objective decision rule. Question #2

A firm believes it can generate an additional $600,000 per year in revenues for the next 6 years if it replaces existing equipment that is no longer usable with new equipment that costs $460,000. The existing equipment is fully depreciated and has a market value of $4,000. The firm...

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