FIN 3104 Lecture Notes - Lecture 19: Nancy Pelosi, Henry Paulson, Barney Frank
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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 7.5%.
0 | 1 | 2 | 3 | 4 | 5 |
HCC | -$610,000 | -$45,000 | -$45,000 | -$45,000 | -$45,000 | -$45,000 |
LCC | -$110,000 | -$170,000 | -$170,000 | -$170,000 | -$170,000 | -$170,000 |
Which unit would you recommend?
Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since HCC's PV of costs is lower than LCC's, HCC would be chosen.
Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since LCC's PV of costs is lower than HCC's, LCC would be chosen.
Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.
Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.
Since all of the cash flows are negative, the IRR's will be negative and we do not accept any project that has a negative IRR.
If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?
The IRR of each project is negative and therefore not useful for decision-making.
The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.
The IRR cannot be calculated because the cash flows are in the form of an annuity.
The IRR of each project will be positive at a lower WACC.
There are multiple IRR's for each project.
If the WACC rose to 15% would this affect your recommendation?
When the WACC increases to 15%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.
Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.
When the WACC increases to 15%, the PV of costs are now lower for LCC than HCC.
When the WACC increases to 15%, the PV of costs are now lower for HCC than LCC.
When the WACC increases to 15%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.
Explain your answer and why this result occurred.
The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.
The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.
The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.
The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.
The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.
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 | 1 | 2 | 3 | 4 | 5 |
HCC | -$590,000 | -$55,000 | -$55,000 | -$55,000 | -$55,000 | -$55,000 |
LCC | -$110,000 | -$175,000 | -$175,000 | -$175,000 | -$175,000 | -$175,000 |
Which unit would you recommend?
Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since LCC's PV of costs is lower than HCC's, LCC would be chosen.
Since we are examining costs, the unit chosen would be the one that had the lower PV of costs. Since HCC's PV of costs is lower than LCC's, HCC would be chosen.
Since all of the cash flows are negative, the IRR's will be negative and we do not accept any project that has a negative IRR.
Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.
Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.
-Select-IIIIIIIVVItem 1
If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?
The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.
The IRR cannot be calculated because the cash flows are in the form of an annuity.
The IRR of each project will be positive at a lower WACC.
There are multiple IRR's for each project.
The IRR of each project is negative and therefore not useful for decision-making.
-Select-IIIIIIIVVItem 2
If the WACC rose to 14% would this affect your recommendation?
When the WACC increases to 14%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.
When the WACC increases to 14%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.
Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.
When the WACC increases to 14%, the PV of costs are now lower for LCC than HCC.
When the WACC increases to 14%, the PV of costs are now lower for HCC than LCC.
-Select-IIIIIIIVVItem 3
Explain your answer and why this result occurred.
The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.
The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.
The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.
The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.
The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.
-Select-IIIIIIIVV
The discounted dividend model can be used to value divisions and firms that do not pay dividends. For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate. For the corporate valuation model, a firm's cost of equity is used as the discount rate. |
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g). From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0). If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied. |
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return. The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital. For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen. The IRR is independent of a firm's weighted average cost of capital. |
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk. Firms with riskier projects generally have a lower WACC. Holding all else constant, an increase in the target debt ratio tends to lower the WACC. |
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes. Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors. On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision. |
If beta < 1.0, the security is less risky than average. According to the Security Market Line (SML), in general, a companyâs expected return will double when its beta doubles. According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate. |
7.37%. 11.05%. 8.32%. |
It ignores cash flows occurring after the payback period. It ignores the time value of money, that is, dollars received in different years are all given the same weight. |
1.82. 2.00. 1.94 |
undervalued. overvalued. |
13.92%. 16.34%. 12.17%. |
$221.86. $195.23. $257.35. |
10.82%. 11.76%. 9.64%. |
10 years. 4.58 years. 6.12 years. |
12.04%. 14.93%. 9.15%. |
1.24 years. 1.62 years. 1.15 years.
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