PRJECT ANALYSIS UNDER CERTAINTY
ANSWERS TO REVIEW QUESTIONS
6.1 Explain and define the terms: net present value, internal rate of return, modified internal rate of return, accounting rate of return, and payback period.
6.2 Explain the role of ‘certainty’ in project evaluation decisions.
6.3 Assume that Anvil Inc. has estimated the following annual data for the introduction of a new product, Ranch Hand:
EOY 0 EOY 1 EOY 2 EOY 3 EOY 4 EOY 5
Cash Flows -14,250 3,700 2,980 6,540 7,810 6,320 Accounting
Income 2,870 2,540 5,890 6,720 5,780
Required rate of return: 14%pa.
Reinvestment rate of return: 12% pa.
(a) For Ranch Hand calculate NPV, IRR, MIRR, ARR, and payback period. (b) Based on the calculations in part (a), make a recommendation to Anvil’s management about the introduction of Ranch Hand.
6.4 With respect to investment decisions, explain the terms: mutual exclusivity, replacement decisions, retirement decisions.
6.5 Discuss the difference in the usage of the terms ‘ asset replacement’ and ‘asset replication’.
6.6 The formula to arrive at an NPV for asset replication in perpetuity is:
Explain how this formula works, and show how it can be set up as a generic calculation within an Excel spreadsheet.
6.7 Assume that White Knuckle Airlines Inc. operates a regional fifty-seat jet aircraft fleet. White Knuckle expects that there will be a constant demand for this type of flight service, and that the model of aircraft employed will remain in production for the foreseeable future. White Knuckle has predicted the set of operational cash flows shown in Table 6.11 for each aircraft.
Table 6.11. Operational cash flows
Year Annual Net Cash Flows $M Salvage Value $M 0 23.00 (cost)
1 4.865 21.0 2 3.956 18.7 3 2.875 16.1 4 2.115 14.3 5 1.875 12.8
If White Knuckle Inc. has a required rate of return of 12% per annum, determine the optimum aircraft replacement cycle time, in perpetuity.
6.8 Kandy Corporation is considering a replacement investment. The machine currently in use was originally purchased two years ago for $65,000. Tax-allowable depreciation is $13,000 per year for five years. The current market value of this machine is $23,000. The new machine being considered would cost $140,000, and require $4,000 shipping cost and $2,000 installation costs. The economic life of the machine is estimated as three years. Tax-allowable depreciation is $70,000 per year for the first two years. If the new machine is acquired, the investments in accounts receivable is expected to increase by $9,000, the inventory by $13,000, and accounts payable by $15,000. The before-tax net operating cash flow is estimated as $120,000 per year for the next three years with the old machine and, $143,000 per year for the next three years with the new machine. The expected resale value of the old and new machines in three years’ time would be $4,000 and $6,600, respectively. The corporate tax rate is 30%.
(a) Calculate the initial investment associated with the proposed replacement decision. (b) Calculate the incremental operating cash flows of the proposed replacement decision. (c) Calculate the terminal cash flows associated with the proposed replacement decision. (d) Compute the NPV of the replacement project assuming a...
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