Ch 13-29 Build a Model Solution

3/6/2001

Chapter 13. Solution for Chapter 13-29 Build a Model

Cummings Products Company is considering two mutually exclusive investments. The projects' expected net cash flows are as follows: Expected net cash flows Project A Project B ($375) ($575) ($300) $190 ($200) $190 ($100) $190 $600 $190 $600 $190 $926 $190 ($200) $0

Time 0 1 2 3 4 5 6 7

a. If you were told that each project's cost of capital was 12 percent, which project should be selected? If the cost of capital was 18 percent, what would be the proper choice? @ a 12% cost of capital WACC = NPV A = NPV B = 12% $226.96 $206.17 @ a 18% cost of capital WACC = NPV A = NPV B = 18% $18.24 $89.54 Use Excel's NPV function as explained in "Ch 13 Tool Kit.xls". Note that the range does not include the costs, which are added separately.

At a cost of capital of 12%, Project A should be selected. However, if the cost of capital rises to 18%, then the choice is reversed, and Project B should be accepted. b. Construct NPV profiles for Projects A and B. Before we can graph the NPV profiles for these projects, we must create a data table of project NPV relative to differing costs of capital. Project A $226.96 $951.00 $790.31 $648.61 $523.41 $412.58 $314.28 $226.96 $149.27 $80.03 $18.24 ($36.98) ($86.39) Project B $206.17 $565.00 $489.27 $421.01 $359.29 $303.35 $252.50 $206.17 $163.85 $125.10 $89.54 $56.85 $26.71

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22%

$1,200 $1,000 $800 $600 $400 $200 $0 0% ($200) 5% 10% 15% 20% 25% 30% 35%

Project A

Project B

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($200)

24% 26% 28% 30%

($130.65) ($170.34) ($205.97) ($237.98)

($1.11) ($26.85) ($50.72) ($72.88)

($400)

c. What is each project's IRR? We find the internal rate of return with Excel's IRR function: IRR A = IRR B = 18.64% 23.92% Note in the graph above that the X-axis intercepts are equal to the two projects' IRRs.

d. What is each project's MIRR at a cost of capital of 12 percent? At k = 18%? (Hint: Consider Period 7 to be the end of Project B's life.) @ a 12% cost of capital MIRR A = MIRR B = 15.43% 17.01% @ a 18% cost of capital MIRR A = MIRR B = 18.34% 20.47%

e. What is the crossover rate, and what is its significance? Cash flow differential $200 ($490) ($390) ($290) $410 $410 $736 ($200)

Time 0 1 2 3 4 5 6 7

Crossover rate =

13.14%

The crossover rate represents the cost of capital at which the two projects have the same net present value. In this scenario, that common net present value, at a cost of capital of 13.13%, is: $182

f. What is the regular payback period for these two projects? Project A Time period: Cash flow: Cumulative cash flow: Logical test: Max Row 93=Payback: Payback: 0 (375) (375) FALSE 0.00 4.38 4.63 1 (300) (675) FALSE 0.00 2 (200) (875) FALSE 0.00 3 (100) (975) FALSE 0.00 4 600 (375) FALSE 0.00 5 $600 225 TRUE 4.38 6 $926 1,151 FALSE 0.00 7 ($200) 951 FALSE 0.00

Alternative calculation using nested IF statements.

Project B Time period: Cash flow: Cumulative cash flow: 0 (575) (575) 1 190 (385) 2 190 (195) 3 190 (5) 4 190 185 5 $190 375 6 $190 565 7 $0 565

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Payback:

3.03

g.

At a cost of capital of 12%, what is the discounted payback period for these two projects? 12%

WACC = Project A

Time period: Cash flow: Disc. cash flow: Disc. cum. cash flow: Discounted Payback:

0 (375) (375) (375) 5.32

1 (300) (268) (643)

2 (200) (159) (802)

3 (100) (71) (873)

4 600 381 (492)

5 $600 340 (152)

6 $926 469 317

7 ($200) (90) 227

Project B Time period: Cash flow: Disc. cash flow: Disc. cum. cash flow: Discounted Payback: 0 (575) (575) (575) 3.98 1 190 170 (405) 2 190 151 (254) 3 190 135 (119) 4 190 121 2 5 $190 108 110 6 $190 96 206 7 $0 0 206

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