Problem 1

Ellmann Systems is considering a project that has the following cash flow and cost of capital (WACC) data. Calculate the project's NPV, IRR, and Payback period. In addition, indicate whether the project is acceptable or not based on each of the three methods. Note that the maximum acceptable payback period is three years.

WACC: 9.00%

Year 0 1 2 3

Cash flows $1,000 $500 $500 $500

Answer:

Calculate in excel:

a. NPV = PV(cash inflows) - PV(cash outflows)

PV (cash inflows) = $1265.65

PV (cash outflows) = $-1,000

NPV = 1,265.65 - 1,000 = $265.65

Base on NPV rule, NPV($265.65)>0, is positive, therefore, this project is acceptable.

b. IRR=23.38%

Base on IRR rule, IRR(23.38%)>WACC(9%), therefore, this project is acceptable.

c. Payback period=1,000/500=4 years

Base on Payback period rule, 4years is greater than 3years, which is required in this project, so this project is not acceptable.

Problem 2

Given that the company's required return (WACC) is 9%, rank the two following projects:

Use only one best method to rank the projects

Project A B

Project life 12 years 12 years

Initial investment $1,200,000 $1,500,000

Annual operating cash flows $180,000 $225,000

Answer:

Calculate in excel:

From the excel, we can see:

IRR of project A and B both are 10.45%, but NPV of project B is $ 111,163.19, is greater than NPV of project A with $ 88,930.55, therefore, base on the NPV rules, Project B is better.

Problem 3

Calculate the sensitivity of the NPV of the project A in Problem 2 above to changes in WACC.

Answer:

When WACC >10.45%, NPV <0, is negative, project A is not acceptable;

When WACC =10.45%, NPV=0, project A can be acceptable depending on managers;

When WACC <10.45%, NPV>0, is positive, project A is acceptable.