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Assignment 5 Finance

This document contains 3 practice problems related to financial management and cash flow analysis. The first problem involves comparing two machine replacement options for a clothing company using net present value and equivalent annual annuity methods. The second problem asks about mutually exclusive project selection and risk adjustment of net present values. The third problem involves calculating the equivalent annual annuity of two investment projects with different cash flow patterns but equal risk and indefinite repeatability.

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572 views

Assignment 5 Finance

This document contains 3 practice problems related to financial management and cash flow analysis. The first problem involves comparing two machine replacement options for a clothing company using net present value and equivalent annual annuity methods. The second problem asks about mutually exclusive project selection and risk adjustment of net present values. The third problem involves calculating the equivalent annual annuity of two investment projects with different cash flow patterns but equal risk and indefinite repeatability.

Uploaded by

Ahmed
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Lahore School of Economics

Financial Management II
Cash Flow Estimation and Risk Analysis – 3
Chapter 12 Assignment 5

Examples
1. Cotner Clothes Inc. is considering the replacement of its old, fully depreciated knitting machine. Two new models are
available: (a) Machine 190-3, which has a cost of $190,000, a 3-year expected life, and after-tax cash flows (labor savings
and depreciation) of $87,000 per year, and (b) Machine 360-6, which has a cost of $360,000, a 6-year life, and after-tax
cash flows of $98,300 per year. Assume that both projects can be repeated. Assume that Cotner’s WACC is 14%. Using the
replacement chain and EAA approaches, which model should be selected? Why?

2. The Butler-Perkins Company (BPC) must decide between two mutually exclusive projects. Each costs $6,750 and has
an expected life of 3 years. Annual project cash flows begin 1 year after the initial investment and are subject to the
following probability distributions:

BPC has decided to evaluate the riskier project at 12% and the less risky project at 10%.

a) What is each project’s expected annual cash flow? Project B’s standard deviation (B) is $5,798, and its coefficient of
variation (CVB) is 0.76. What are the values of A and CVA?
b) Based on the risk-adjusted NPVs, which project should BPC choose? BPC has decided to evaluate the riskier project at
12% and the less risky project at 10%.

Problems for Assignment


1. Wisconsin Dairy Inc. is deciding on its capital budget for the upcoming year. Among the projects being considered are
two machines, W and WW. W costs $500,000 and will produce expected after-tax cash flows of $300,000 during the next 2
years. WW also costs $500,000, but it will produce after-tax cash flows of $165,000 during the next 4 years. Both projects
have a 10% WACC.
a. If the projects are independent and not repeatable, which project(s) should the company accept?
b. If the projects are mutually exclusive but are not repeatable, which project should the company accept?
c. Assume that the projects are mutually exclusive and can be repeated indefinitely.
i) Use the replacement chain method to determine the NPV of the project selected.
ii) Use the equivalent annual annuity method to determine the annuity of the project selected.

2. Huang Industries is considering a proposed project whose estimated NPV is $12 million. This estimate assumes that
economic conditions will be “average.” However, the CFO realizes that conditions could be better or worse, so she
performed a scenario analysis and obtained these results:
Calculate the project’s expected NPV, standard deviation, and coefficient of variation.
3. A firm has two mutually exclusive investment projects to evaluate; both can be repeated indefinitely. The projects have
the following cash flows:

Tim Project X Project Y


e
0 ($100,000) ($70,000)
1 30,000 30,000
2 50,000 30,000
3 70,000 30,000
4 - 30,000
5 - 10,000

Projects X and Y are equally risky and may be repeated indefinitely. If the firm’s WACC is 12%, what is the EAA of
the project that adds the most value to the firm?

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