Choosing mandatory projects on the basis of least cost Kim Inc. must install a n

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Choosing mandatory projects on the basis of least cost

Kim 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 would 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 low operating 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 WACC is 7.5%.

Which unit would you recommend?

Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since HCC's PV of costs is lower than LCC's, HCC would be chosen.

Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since LCC's PV of costs is lower than HCC's, LCC would be chosen.

Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.

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.

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.

If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?

The IRR of each project is negative and therefore not useful for decision-making.

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.

The IRR cannot be calculated because the cash flows are in the form of an annuity.

The IRR of each project will be positive at a lower WACC.

There are multiple IRR's for each project.

If the WACC rose to 15% would this affect your recommendation?

When the WACC increases to 15%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.

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.

When the WACC increases to 15%, the PV of costs are now lower for LCC than HCC.

When the WACC increases to 15%, the PV of costs are now lower for HCC than LCC.

When the WACC increases to 15%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.

Explain your answer and why this result occurred.

The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.

The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.

The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.

The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.

The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.

Explanation / Answer

a) Which unit would you recommend? Explain. As HCC and LCC are maintenance projects, the firm should be concerned about minimising total cash outflows, and should select the project that has the lowest negative NPV: NPV for HCC = NpV(rate,vlues1,value2,...5)+Cost = $792,065

NPV for LCC = NpV(rate,vlues1,value2,...5)+Cost = -$797,800 .

Thus, unit HCC should be selected as it has the lowest negative NPV and will minimise the present value of future cash outflows.

b) If Kim’s controller wanted to know the IRRs of the two projects, what would you tell him?

Answer

You would tell the controller than it is not possible to calculate an IRR for either of these projects, as they are maintenance projects and there are no changes in cash flow sign over the life of the projects.

c) If the WACC rose to 15% would this affect your recommendation? Explain your answer and the reason this result occurred.

NPV for HCC = NpV(rate,vlues1,value2,...5)+Cost = -$760,847

NPV for LCC = NpV(rate,vlues1,value2,...5)+Cost = -$679,866

With an increase in the WACC from 7.5% to 15%, the PV of the costs (cash outflows) are now lower for unit LCC rather than unit HCC, and unit LCC would be the preferable choice. The reason for this change is that when you discount at a higher discount rate you are making negative cash flows smaller and thus improving the results, unknowingly. Thus, if you were trying to risk adjust for a riskier project that consisted just of negative cash flows then you would use a lower cost of capital rather than a higher discount rate.

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