# Explain.

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Use the following information for problems 1 to 5. Assume that the projects are mutually exclusive.
Year
Cash Flow (A)
Cash Flow (B)
0
(\$1,525,600)
(\$1,425,600)
1
\$683,100 \$655,900 2
\$480,200 \$463,900 3
\$745,000 \$675,000 4
\$308,000 \$279,000 1. What is the IRR for each of these projects? Using the IRR decision rule, which project should the company accept? Is this decision necessarily correct?
2. If the required return is 13 percent, what is the NPV for each of these projects? Which project will the company choose if it applies the NPV decision rule?
3. Over what range of discount rates would the company choose Project A? Project B? At what discount rate would the company be indifferent between these two projects? Explain.
4. Compute the payback period for each project.
5. Compute the profitability index for each project.
Use the data below for problems 6 to 10.
Year
Proj Y
Proj Z
0
(\$210,000)
(\$210,000)
1
200,000
95,000
2
95,000
78,000
3

73,000
4

87,500
The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have an 11% cost of capital.
6. What is each project’s initial NPV without replication?
7. What is each project’s equivalent annual annuity?
8. Now apply the replacement chain approach to determine the shorter projects’ extended NPV. Which project should be chosen?
9. Now assume that the cost to replicate Project Y in 2 years will increase to \$240,000 because of inflationary pressures. How should the analysis be handled now, and which project should be chosen?
10. You are also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the project’s estimated cash flows:
Yr
CF
Salvage
0
(\$89,000)
\$89,000 1
31,200
48,000
2
45,400
39,000
3
52,750
0
Using the 13% cost of capital, what is the project’s NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the project’s optimal (economic) life?
11. Suppose you have a project that will cost \$500,000 last for ten years. The cash flows for each year have an expected value of \$100,000 with a standard deviation of \$15,000. The cost of capital is 10%. Use a Monte Carlo simulation with 1,000 replications to evaluate this project using the NPV and IRR approaches. See the video below for constructing the Excel spreadsheet.
Some videos you may find helpful.
Relevant Cash Flows
Accounting Rate of Return
Payback Period
NPV
Profitability Index
Internal Rate of Return
IRR – Mutually Exclusive Projects
IRR – Nonconventional Cash Flows
Modified IRR
Projects with Unequal Lives
Proforma Income Statement – Capital Budgeting
Let’s return to the proforma income statement we created for Tesla (info given below) that we did in Week 2 and complete the analysis to determine if the project is desirable. Using the spreadsheet you constructed in Week 2 and the cost of capital calculations you computed in Week 8 to determine if Tesla should do the Cheetah project. Use the following capital budgeting techniques.
1. Payback period
2. Net present value
3. Internal rate of return Now let’s test the sensitivity of the project to some changes in the assumptions.
4. Take the cost of capital you previously computed (in week 8) and add 4% to the value (for example, if WACC was 12%, make it 16%) and recalculate NPV. What happens to IRR? Is the project still desirable?
5. Suppose the cost of goods sold percentage rises by 2.5%. Compute the payback period, NPV and IRR. Use the original WACC you computed.
6. How sensitive is NPV to the changes made in 4 and 5?Suppose Tesla (ticker symbol – tsla) has decided to introduce an electric minivan, the Model MV. Before they launch the Model MV, they conducted an analysis to see if the Model MV would be a desirable investment. The company estimated that it would sell 500,000 Model MV’s per year at a price of \$65,000 for the next six years. After the first year of sales, the quantity sold will increase by 4% per year for the remaining life of the project.
The initial capital outlay is determined to be \$5.5 billion and a \$1.5 billion outlay in net working capital (NWC) would also be required. Assume that there is a one-time investment in NWC and that this will be recovered at the end of the project.
Assume that the equipment used will be depreciated using the MACRS 7 year schedule and that the equipment has a salvage value of zero. At the end of year 6, the equipment will be sold for 120% of its book value. Also, assume that that the tax rate is 25%.
Using information from Tesla’s financial statements (you may want to use Morningstar.com or some other online site) estimate the operating cash flows from the project. Make any simplifying assumptions that are necessary to produce the estimate.

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