investment has the higher IRR?
- b. Which
investment has the higher NPV when the cost of capital is 7%?
Substituting r = 0.07 into the NPV formulas derived in part (a) gives
NPVA = $18.5714 million, NPVB = $20 million. So the NPV says take B.
- c. In
this case, for what values of the cost of capital does picking the higher
IRR give the correct answer as to which investment is the best
2. Pisa Pizza, a seller of frozen pizza, is considering
introducing a healthier version of its pizza that will be low in cholesterol
and contain no trans fats. The firm expects that sales of the new pizza will be
$20 million per year. While many of these sales will be to new customers, Pisa
Pizza estimates that 40% will come from customers who switch to the new,
healthier pizza instead of buying the original version.
a. Assume customers will spend
the same amount on either version. What level of incremental sales is
associated with introducing the new pizza?
b. Suppose that 50% of the
customers who will switch from Pisa Pizza’s original pizza to its healthier
pizza will switch to another brand if Pisa Pizza does not introduce a healthier
pizza. What level of incremental sales is associated with introducing the new
pizza in this case?
3. Cellular Access, Inc. is a cellular telephone service
provider that reported net income of $250 million for the most recent fiscal
year. The firm had depreciation expenses of $100 million, capital expenditures
of $200 million, and no interest expenses. Working capital increased by $10
million. Calculate the free cash flow for Cellular Access for the most recent
4. A bicycle manufacturer currently produces 300,000 units a
year and expects output levels to remain steady in the future. It buys chains
from an outside supplier at a price of $2 a chain. The plant manager believes
that it would be cheaper to make these chains rather than buy them. Direct
in-house production costs are estimated to be only $1.50 per chain. The
necessary machinery would cost $250,000 and would be obsolete after 10 years.
This investment could be depreciated to zero for tax purposes using a 10-year
straight-line depreciation schedule. The plant manager estimates that the
operation would require $50,000 of inventory and other working capital upfront
(year 0), but argues that this sum can be ignored because it is recoverable at
the end of the 10 years. Expected proceeds from scrapping the machinery after
10 years are $20,000.
If the company pays tax at a rate of 35% and the opportunity
cost of capital is 15%, what is the net present value of the decision to
produce the chains in-house instead of purchasing them from the supplier?