Problem Set 5
Your factory has been offered a contract to produce a part for a new printer. The contract
would last for three years and your cash flows from the contract would be $5 million per year.
Your up-front setup costs to be ready to produce the part would be $8 million. Your cost of
capital for this contract is 8%.
a) Will your factory accept this contract?
b) What does the NPV rule say you should do?
If you take the contract, what will be the change in the value of your firm?
You are considering opening a new plant. The plant will cost $100 million up-front and will take
one year to build. After that, it is expected to produce profits of $30 million at the end of every
year of production. The cash flows are expected to last forever. Calculate the NPV of this
investment opportunity if your cost of capital is 8%. Should you make the investment?
Calculate the IRR and use it to determine the maximum deviation allowable in the cost of
capital estimate to leave the decision unchanged.
Your firm is considering the following two projects and can only take one. The cost of capital
for both these projects is 10%.
Project A ($mln)
Project B ($mln)
What is the NPV of each project at your cost of capital?
b) What is the IRR of each project?
What is the payback period of each project?
d) What is going to be your investment decision? Would your decision be different if the
two projects were not mutually exclusive?
Make a sketch of the NPV profile of both projects in the figure below. Try to think about
which points of each of the NPV lines are easy to find without much calculation. When
you look at the cash flows of both projects, can you see which project will be favoured
by a low discount rate, and which project will be favoured by a high discount rate?
How would your investment decision change if both projects required clean-up cost of
$50 million at the end of the 6
year? What would happen to the NPV's of the projects?
And what would happen to the IRR's?