11-14 CHOOSING MANDATORY PROJECTS ON THE BASIS OF LEAST COST Kim Inc. must insta

Question

11-14 CHOOSING MANDATORY PROJECTS ON THE BASIS OF LEAST COST Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the units otherwise, the highly profitable plant would have to shut down. Two units are available,HCC and LCC (for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs, while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the units are shown here. Kim's WACC is 7%. 0 4 HCC -$600,000$50,000$50,000-$50,000-$50,000$50,000 LCC -$100,000 -$175,000-$175,000-$175,000-$175,000 -$175,000 a. Which unit would you recommend? Explain. b. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him? C. If the WACC rose to 15% would this affect your recommendation? Explain your answer and the reason this result occurred.

Explanation / Answer

a) We would recommend the unit that has higher NPV.

NPV = CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2 + ... CF5 / (1 + r)^5

For HCC, NPV = -600,000 - 50,000 / 1.07 - 50,000 / 1.07^2 .... - 50,000 / 1.07^5 = - 805,010

For LCC, NPV = -100,000 - 175,000 / 1.07 - 175,000 / 1.07^2 .... - 175,000 / 1.07^5 = - 817,535

As HCC has lower cost than LCC, we would recommend HCC.

b) IRR is the internal rate of return, which cannot be calculated in this case as no machine has positive cash flows.

c) If r = 15%,

NPV for HCC = -767,608

NPV for LCC = -686,627

Now, LCC has lower cost than HCC and hence, we recommend LCC.

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