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Lecture 6

ADMS 3530 Lecture Notes - Lecture 6: Cash Flow, Project Y, Opportunity Cost


Department
Administrative Studies
Course Code
ADMS 3530
Professor
Lois King
Lecture
6

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Final: 3 hrs, 50questions
1-32: numerical (6-7 questions will cover 1st half course)
33-50: conceptual (no question about 1st half course)
Past final tips:
1. (Fall 07 final) Snowing Inc. is considering the following three projects. Its opportunity
cost of capital is 8%.
Project Initial
Investment
Cash Flow
Year 1
Cash Flow
Year 2
Cash Flow
Year 3
Cash Flow
Year 4
X -$3,000 $1,200 $1,000 $3,000 $0
Y -$1,000 $0 $1,200 $0 $1,000
Z -$5,000 $1,000 $1,000 $3,000 $2,000
(a) Given that Snowing Inc. uses the payback rule with a cutoff period of 2
years, which project(s) would the firm choose?
A) Project X only
B) Project Y only
C) Project Z only
D) None of the projects
Solution: B
CF's Cumul. CF Discoun. CF Cumul. DCF
Project X
0 -3000 -3000 -3000 -3000
1 1200 -1800 1111.11 -1888.89
2 1000 -800 857.34 -1031.55

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3 3000 2200 2381.50 1349.95
4 0 2200 0.00 1349.95
Project Y
0 -1000 -1000 -1000 -1000
1 0 -1000 0 -1000
2 1200 200 1028.81 28.81
3 0 200 0 28.81
4 1000 1200 735.03 763.84
Project Z
0 -5000 -5000 -5000 -5000
1 1000 -4000 925.93 -4074.07
2 1000 -3000 857.34 -3216.73
3 3000 0 2381.5 -835.23
4 2000 2000 1470.06 634.83
The payback periods for the projects are: 2.27 years for Project X, 1.83 years for
Project Y, and 3 years for Project Z.
(b) If the firm uses a cutoff period of 3 years with the discounted payback
rule, which project(s) would Snowing Inc. accept?
A) Project X only
B) Projects X and Y
C) Projects X and Z
D) None of the projects
Solution: B
See table above.

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The discounted payback periods for the projects are: 2.43 years for Project X,1.97 years for
Project Y, and 3.57 years for Project Z.
2. Which of the following statements is most likely correct for a project costing $50000 and
returning $14000 per year for five years?
a. NPV=$3071.01
b. NPV=$20000
c. IRR=2.8%
d. IRR is greater than 10%
Answer: d
CF0=-50000, c01=14000, f01=5->CPT IRR=12.38
3. You can continue to use your less efficient machine at a cost of $8,000
annually for the next five years. Alternatively, you can purchase a more efficient
machine for $12,000 plus $5,000 annual maintenance over the next five years. At a
cost of capital of 15%, you should:
A) Buy the new machine and save $600 annually
B) Buy the new machine and save $388 annually
C) Keep the old machine and save $388 annually
D) Keep the old machine and save $580 annually
Solution: D
CF0=12000, C01=5000,F01=5-> NPV-> I=15->CPT NPV=28760.7755
EAC= PV/5 year annuity factor=28760.7755/3.352155=8579.7869
8579.7869-8000=579.7869
4. If a project’s IRR is 13% and the project provides annual cash flows of $15000 for four
years, how much did the project cost?
a. $44617
b. $52200
c. $60000
d. $72747
Answer: a
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