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Problems: 1) Gander, Inc. is considering two projects with the following cash flows: Year Project X Project Y 0 ($100,000) ($100,000) 1 40,000 50,000 2 40,000 0 3 40,000 0 4 40,000 0 5 40,000 0 Gander uses the payback period method of capital budgeting and accepts only projects with payback periods of 3 years or less. a. If the projects are presented as stand-alone opportunities, which one(s) would Gander accept? If they were mutually exclusive and Gander disregarded its three-year rule, which project would be chosen? b. Is there a flaw in the thinking behind the correct answers to part (a)? 2) A project has the following cash flows: C0 C1 $(700) $200 C2 $500 C3 $244 a. What is the project’s payback period? b. Calculate the project’s NPV at 12%. c. Calculate the project’s PI at 12%. 5) Should the project being considered in the previous problem be accepted or rejected based on IRR? (HINT: start by guessing 11% for IRR.) Does the IRR method seem to give a more definite result? If so, would your recommendation after considering all four methods be strong or cautious? 9) Calculate the NPV at 12% and the IRR for the following projects. Find IRRs to the nearest whole percent. a. An initial outflow of $10,000 followed by three inflows of $4,000. b. An initial outflow of $10,000 followed by inflows of $3,000, $4,000, and $5,000. c. An initial outflow of $10,000 followed by inflows of $5,000, $4,000, and $3,000. d. Notice that in parts (a), (b), and (c), a total of $12,000 is received over three years. Compare the NPVs and IRRs to see the impact of shifting $2,000 between years one and three. 15) Island Airlines Inc. needs to replace a short-haul commuter plane on one of its busier routes. Two aircraft are on the market that satisfies the general requirements of the route. One is more expensive than the other is but has better fuel efficiency and load-bearing characteristics, which result in better long-term profitability. The useful life of both planes is expected to be about seven years, after which time both are assumed to have no value. Cash flow projections for the two aircraft follow: Initial cost Cash inflows, years 1 through 7 Low Cost High Cost $775,000 $950,000 154,000 176,275 a. Calculate the payback period for each plane and select the best choice. b. Calculate the IRR for each plane and select the best option. Use the fact that all the inflows can be represented by an annuity. C. Compare the results of parts (a) and (b). Both should select the same option, but does one method result in a clearer choice than the other based on the relative sizes of the two-payback periods versus the relative sizes of the two IRRs? d. Calculate the NPV and PI of each project assuming a cost of capital of 6%. Use annuity methods. Which plane is selected by NPV? BY PI? e. Calculate the NPV and PI of each project, assuming the following costs of capital: 2%, 4%, 6%. 8% and 10%. Use annuity methods. Is the same plane selected by NPV and PI at every level of cost of capital? Investigate the relative attractiveness of the two planes under each method. f. Use the results of parts (b) and (e) to sketch the NPV profiles of the two proposed planes on the same set of axes. Show the IRRs on the graph. Would NPV and IRR ever give conflicting results? Why? 16) Bagel Pantry Inc. is considering two mutually exclusive projects with widely differing lives. The company’s cost of capital is 12%. The project cash flows are summarized as follows: C0 Project A Project B $(25,000) $(23,000) C1 14,742 6,641 C2 14,742 6,641 C3 14,742 6,641 C4-C9 6,641 a. Compare the projects using payback b. Compare the projects using NPV c. Compare the projects using IRR d. Compare the projects using the replacement chain approach. e. Compare the projects using the EAA method. f. Choose a project and justify your choice
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I was having a hard time with this subject, and this was a great help.