Use the following for Questions 1 - 4: You are considering two mutually exclusiv

Question

Use the following for Questions 1 - 4:

You are considering two mutually exclusive projects, A and B.

Project A costs $65,000 and generates cash flows of $11,000 for 10 years.

Project B costs $100,000 and generates cash flows of $10,000 per year for five years and then a cash flow of $105,000 in year 6. There are no cash flows after year 6 for Project B.

Report rates in percentage form to two decimal places i.e. 10.03% not 10%

1). At what discount rate would make you indifferent between choosing one project or another?

2). Which project would you ACCEPT if your discount rate was 9%?

A. project A B. project B C.Both Project A and B    D.Neither Project A or B

3). Which project would you ACCEPT if your discount rate was 5%?

A. project A B. project B C.Both Project A and B    D.Neither Project A or B

4) What is the highest discount rate in which you can still produce a non-negative NPV?

Explanation / Answer

1. Indifference rate is the rate with which , when all the cash flows of different projects are discounted, their NPVs are equal--- because of this,the investor is indifferent to selection of either project. Project A's Cash flows:    -65000+(11000*(1-(1+r)^-10)/r) Project B's Cash flows: -100000+(10000*(1-(1+r)^-5)/r)+(105000/(1+r)^6) Equating both the cash flows -65000+(11000*(1-(1+r)^-10)/r)=-100000+(10000*(1-(1+r)^-5)/r)+(105000/(1+r)^6) Solving in an online equation solver, we get the indifference rate r as = 0.061226 6.12% 2. NPV at   r=9% Project A's Cash flows:    -65000+(11000*(1-(1+0.09)^-10)/0.09)= 5594.23 Project B's Cash flows: -100000+(10000*(1-(1+0.09)^-5)/0.09)+(105000/(1+0.09)^6) 1504.58 A. Accept Project A (Greater NPV) 3. NPV at   r=5% Project A's Cash flows:    -65000+(11000*(1-(1+0.05)^-10)/0.05)= 19939.08 Project B's Cash flows: -100000+(10000*(1-(1+0.05)^-5)/0.05)+(105000/(1+0.05)^6)= 21647.38 B. Accept Project B (Greater NPV) 4) Highest discount rate which still produces a non-negative NPV Is the respective projects IRR, ie. The rate at which PVs of both the cash inflows & outflows are equal & the NPV is 0 So,equating the cash flows to 0, we have,for Project A 0=-65000+(11000*(1-(1+r)^-10)/r) r= IRR= 0.109198 10.92% Project B 0=-100000+(10000*(1-(1+r)^-5)/r)+(105000/(1+r)^6) r= IRR= 0.093411 9.34%

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