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Chapter 4: Q22BP (page 412)

The Suboptimal Glass Company uses a process of capital rationing in its decision making. The firm鈥檚 cost of capital is 10 percent. It will only invest \(77,000 this year. It has determined the internal rate of return for each of the following projects:

Project

Project size

Internal rate of return

A

\)10,500

21%

B

30,500

22

C

25,500

18

D

10,500

13

E

10,500

20

F

20,500

11

G

10,500

16

a. Select the projects that the firm should accept.

b. If Projects A and B are mutually exclusive, how would that affect your overall answer? That is, which projects would you accept in spending the $77,000?

Short Answer

Expert verified

Answer

  1. The business entity must accept projectsB, A, E, and C.

  2. Project A will be replaced by project G.

Step by step solution

01

Definition of Profitability Index

The profitability index is the metric that determines the attractiveness of the different available projects to make an investment decision. Under this metric, the present value of the cash flows generated from the investment is compared with the initial investment.

02

Selection of the project

Ranking of investment as per IRR:

Project

IRR

Project Size

Total budget

B

22%

$30,500

$30,500

A

21

10,500

41,000

E

20

10,500

51,500

C

18

25,500

77,000

G

16

10,500

87,500

D

13

10,500

98,000

F

11

20,500

118,500

As the business entity wishes to invest only $77,000, it must accept projects B, A, E, and C as they are ranked in the first four projects according to IRR.

03

Selection of project when projects A and B are mutually exclusive

If the project A and project B are mutually exclusive, then the business entity should select project B. The other three projects will be E, C, and G. Project A will be replaced by project G as they have the same project size.

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Most popular questions from this chapter

If, as an investor, you had a choice of daily, monthly, or quarterly compounding, which would you choose? Why?

Keller Construction is considering two new investments. Project E calls for the purchase of earthmoving equipment. Project H represents an investment in a hydraulic lift. Keller wishes to use a net present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project E (\(20,000 Investment)

Year

Cash flows

1

\)5,000

2

6,000

3

7,000

4

10,000

Project H (\(20,000 Investment)

Year

Cash flows

1

\)16,000

2

5,000

3

4,000

  1. Determine the net present value of the projects based on a zero percent discount rate.

  2. Determine the net present value of the projects based on a 9 percent discount rate.

  3. The internal rate of return on Project E is 13.25 percent, and the internal rate of return on Project H is 16.30 percent. Graph a net present value profile for the two investments similar to Figure12-3. (Use a scale up to \(8,000 on the vertical axis, with \)2,000 increments. Use a scale up to 20 percent on the horizontal axis, with 5 percent increments.)

  4. If the two projects are not mutually exclusive, what would your acceptance or rejection decision be if the cost of capital (discount rate) is 8 percent? (Use the net present value profile for your decision; no actual numbers are necessary.)

  5. If the two projects are mutually exclusive (the selection of one precludes the selection of the other), what would be your decision if the cost of capital is (1) 6 percent, (2) 13 percent, (3) 18 percent? Once again, use the net present value profile for your answer.

Question: Mrs. Crawford will receive $7,600 a year for the next 19 years from her trust. If a 14 percent interest rate is applied, what is the current value of the future payments?

Question: Phil Goode will receive $175,000 in 50 years. His friends are very jealous of him. If the funds are discounted back at a rate of 14 percent, what is the present value of his future 鈥減ot of gold鈥�?

Essex Biochemical Co. has a $1,000 par value bond outstanding that pays 15 percent annual interest. The current yield to maturity on such bonds in the market is 17 percent. Compute the price of the bonds for these maturity dates:

a. 30 years.

b. 20 years.

c. 4 years.
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