Problem: You are interested in purchasing a shoe machine XYZ, especially designed for men's fashion shoes. The machine costs $10,000. You expect to recover $6,000 a year in operating cash flows for only two years because of rapidly changing fashions. You estimate the salvage value of the machine at the end of two years to be $1,200. Assume that the tax rate is zero. Assume that the $6,000 per year after tax operating cash flow is received at the end of each year.

Required:

Question 1: What is the Net Present Value (NPV) of this project, if cash flows are to be discounted at 20% cost of capital?

Question 2: What is the IRR of this project?

You decide to invest in machine XYZ. But just before you place an order for the machine you hear about another machine UVW. This machine costs $15,000 and has operating flows of $18,000 during the first year and, for some unknown reason, only $50 during the second year, with no salvage value at the end of two years. (Assume all cash flows occur at the end of the year for the purpose of discounting.)

Question 3: You know that whether you prefer XYZ or UVW depends upon your cost of capital. Draw the graph showing how NPVs of these two machines relate to their cost of capital. Both NPVs should be on the same graph.

Question 4: At what cost of capital both machines have the same Net Present Value? (Please do not forget to show the equation you need to solve with the help of Excel to answer this question).

Question 5: What is the IRR of machine UVW?

Question 6: Without making any further calculations, state the region(s) of cost of capital that make XYZ preferable to UVW, assuming you must choose either one of these machines but not both.