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Chapter 4 Selected Questions with Solutions

1.

Demonstrate that shareholders would be better off if their firm rejected a project costing $4 million, and returned a cash flow of $4.30 million in a years time, given an opportunity cost of capital of 10%.
ANSWER

Recall from Chapter 1 that Fishers separation theorem states that managers should invest in projects until the rate of return on the marginal project equals the market rate of interest. The market rate of interest is the interest an investor could expect to receive from a project of the same risk. In this case, we need to compare the present value of the cash flows from the project with the outlay required to undertake the project.
NPV

1 r

CF

C0

4.3 4 $0.09 million 1.1

The present value of the projects future cash flows is less than the outlay required for the project. Accepting this project will reduce shareholder wealth by $0.9 million. If the shareholders had these funds to invest instead of the company, they would be able to achieve a rate of return of 10% on a project of this risk. Accepting this project will reduce shareholders wealth 2. If the net present value of a project is positive, the internal rate of return must be less than the required rate of return. True or false?
ANSWER

False. If a project has a positive NPV then the internal rate of return must be greater than the required rate of return. 3. Two projects with the same net present values will have the same internal rates of return. True or false?
ANSWER

True.

1.

Should the following project be accepted? (Opportunity cost of capital is 15%.) Year Net cash flows 0 -120 1 40 2 30 3 40 4 50 5 60

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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ANSWER

Year Net cash flows Present value = Net present value

0 -120

-120 22.18

1 40 40 1.15 34.78

2 30 30 1.152 22.68

3 40 40 1.153 26.30

4 50 50 1.15 4 28.59

5 60 60 1.155 29.83

The present value of the cash flows, $142.19, exceeds the initial outlays of $120.00 by $22.19. That is, the net present value of the project is positive and it should be accepted. Accepting the project will increase the wealth of investors by $22.19; that is, they will earn $22.19 in todays dollars over and above the market rate of return of 15% that they could achieve without the project.

2.

Consider the following projects: Year Project A Project B Project C (a) (b) (c) 0 -1,000 -6,000 -10,000 1 1,000 1,000 1,000 2 1,000 2,000 3 4,000 3,000 4 1,000 4,000 5 1,000 5,000

If the cost of capital is 8%, which of the projects have a positive NPV? Calculate the payback period and the discount payback for each project. Which of the projects would a firm using the payback method accept if its policy were to accept all projects with a payback period of 3 years or less? What is the internal rate of return on Project A? What is it on Project B?

(d) (e)

If you could choose only one of these three projects (they are mutually exclusive), which one would you choose? Why?

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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ANSWER

(a)

Net Present Value 0 -1,000 -1,000 -1,000 -74.07 -6,000 -6,000 -10,000 374.21 -10,000 1 1,000 1000 1.08 925.93 1,000 1000 1.08 925.93 1,000 1000 1.08 925.93 2 3 4 5

Year Project A Present value = NPV Project B Present value = NPV Project C Present value = NPV (b) Payback

1,000 1000 1.082 857.34

4,000 4000 1.083 3175.33

1,000 1000 1.084 735.03

1,000 1000 1.085 680.58

-10,000 1,365.14

2,000 3,000 4,000 5,000 2000 3000 4000 5000 2 3 4 1.08 1.08 1.08 1.085 1714.68 2381.50 2940.12 3402.92

Year 0 1 Project A -1,000 1,000 Payback period = 1 year Project B -6,000 1,000 Payback period = 3 years Project C -10,000 1,000 Payback period = 4 years Discounted Payback

1,000 2,000

4,000 3,000

1,000 4,000

1,000 5,000

Year 0 1 2 3 4 5 Project A -1,000 1,000 Discount CFs -1,000 -74.07 Cum. DCFs -74.07 Payback period = No result. Outlay is not recovered. Project B -6,000 1,000 1,000 4,000 1,000 1,000 Discount CFs -6,000 925.93 857.34 3175.33 735.03 680.58 Cum. DCFs -6,000 -5074 -4217 -1041 -306 374 Payback period = 4.45. Project C -10,000 1,000 2,000 3,000 4,000 5,000 Discount CFs -10,000 925.93 1714.68 2381.50 2940.12 3402.92 Cum. DCFs -10,000 -9074 -7359 -4978 -2038 1365 Payback period = 4.40. (c) If the maximum acceptably payback period is 3 years, a firm would accept projects A (1 year) and B (3 years).

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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(d)

Internal Rate of Return 2 3 4 5

Year 0 1 Project A -1,000 1,000 Internal Rate of Return = 0%. Project B -6,000 1,000 Internal Rate of Return = 10.28%. Project C -10,000 1,000 Internal Rate of Return = 12.01%. (e)

1,000 2,000

4,000 3,000

1,000 4,000

1,000 5,000

Based on a cost of capital of 8%, projects C and B have positive NPVs with Project C the superior. Project A has the best payback period but a zero IRR and a negative NPV.

3.

You are evaluating two capital projects, X and Y, only one of which can be implemented. The projects have the following IRR and NPV (calculated at the firms cost of capital). Project X 12% $140,000 Project Y 17.5% $75,000

IRR NPV (a) (b)

Within what range of values does the firms cost of capital lie? What characteristics of the cash flows associated with these two projects might give rise to this type of relationship between the IRR and the NPV? Which project should be chosen?

(c)

ANSWER

(a)

The firms cost of capital must be less than 12%, because both projects have a positive NPV, and the lowest internal rate of return is 12%. Therefore the range must be 0% to 12% Project X is probably a bigger project, because although it has a lower internal rate of return it has a greater NPV. I would choose project X, because it has the higher NPV.

(b)

(c)

4.

You are evaluating two capital projects, X and Y, only one of which can be implemented (they are mutually exclusive). The projects have the following cash flows: Year Project X Project Y 0 -2,700 -2,700 1 1,400 300 2 1,100 800 3 800 1,100 4 200 1,600

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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(a) (b) (c)

What is the crossover rate for these two projects? Which project should be chosen if the cost of capital is 5%? Which project should be chosen if the cost of capital is 10%?

ANSWER * CROSS OVER WAS 7.22% SHOULD BE 7.72%

(a)

NPV
t 0

1 k crossover t
1400 1100 800 200 2 3 1 k crossover 1 k crossover 1 k crossover 1 k crossover 4 300 800 1100 1600 2 3 1 k crossover 1 k crossover 1 k crossover 1 k crossover 4

CFt

NPVX 2700 NPVY 2700 NPVX NPVY

1100 300 300 1400 0 2 3 1 k crossover 1 k crossover 1 k crossover 1 k crossover 4


n

k `crossover 7.72%

(b)

NPV
t 0

1 k t

CFt

1400 1100 800 200 $486.68 2 3 1.05 1.05 1.05 1.054 300 800 1100 1600 NPVY 2700 $577.88 2 3 1.05 1.05 1.05 1.054 NPVX 2700
Project Y should be chosen. (c)

1400 1100 800 200 $219.47 2 3 1.10 1.10 1.10 1.104 300 800 1100 1600 NPVY 2700 $153.15 2 3 1.10 1.10 1.10 1.104 NPVX 2700
Project X should be chosen.

5.

You are evaluating two mutually exclusive projects, project X and project Y. The cost of capital is 14%, and the projected cash flows of these two projects are as follows: Year Project X Project Y 0 -3,000 -4,500 1 1,200 1,797 2 1,500 1,200 3 450 1,800 4 600 1,050 5 1,200 1,200

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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(a) (b) (c)

Based on the NPV technique, which project should be accepted? Based on the IRR technique, which project should be accepted? Draw the NPV profiles of these two projects, and discuss why the NPV and IRR techniques provide different conclusions?

ANSWER

(a)

NPV
t 0

1 k t

CFt

1200 1500 450 600 1200 $489.06 2 3 4 1.14 1.14 1.14 1.14 1.145 1797 1200 1800 1050 1200 NPVY 4500 $459.55 2 3 4 1.14 1.14 1.14 1.14 1.145 NPVX 3000
Project X should be accepted. (b)

NPV
t 0

1 IRRt

CFt

NPVX 3000

1200 1500 450 600 1200 2 3 4 1 IRR 1 IRR 1 IRR 1 IRR 1 IRR5

$0 IRRX 21.22% NPVY 4500 1797 1200 1800 1050 1200 2 3 4 1 IRR 1 IRR 1 IRR 1 IRR 1 IRR5

$0 IRRX 18.49%
Project X should be accepted.

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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(c)
3000 2500 2000

NPV

1500 1000 500 0 -500 0% 5% 10% 15% 20% 25%

Project X Project Y

Cost of Capital

Based on a cost of capital of 14%, the NPV and IRR techniques give the same result. It can be seen from the above diagram that the intersection of the NPV profile with the x-axis gives the internal rate of return 21.22% and 18.49% for projects X and Y respectively. Project X has a higher IRR than Project Y. However, the differing scale of these projects means that there is a different shape to the NPV profiles. The crossover cost of capital (the cost of capital at which the NPV of the projects are equal) is at 13.14%. For all costs of capital greater than the crossover cost of capital, the NPV of project X is greater. At a cost of capital of 14%, project X is still preferred under the NPV technique. If the NPV is calculated using a cost of capital less than 13.14%, Project Y has a higher NPV and should be chosen.

6.

You are evaluating two pieces of equipment for the company, a truck and an overhead pulley system. A truck has a low initial cost but high annual operating costs, and an overhead pulley system costs more but has lower operating costs. The cost of capital is 10%, and the equipments expected net costs are as follows: Year Truck Pulley (a) 0 -110,000 -240,000 1 -82,000 -49,000 2 -82,000 -50,000 3 -82,000 -50,000 4 -82,000 -50,000 5 -82,000 -50,000 Which

What is the present value of costs of each piece of equipment? equipment should be chosen? If the cost of capital is 7%, which equipment should be chosen?

(b)

ANSWER

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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(a)

CFt t 1 k t 0 82 82 82 82 82 NPVT 110 $420,845 2 3 4 1.10 1.10 1.10 1.10 1.105 49 50 50 50 50 NPVP 240 $428,630 2 3 4 1.10 1.10 1.10 1.10 1.105 NPV
The present value of the cost of the truck is -$420,845 and that of the pulley is $428,630. Hence the truck should be chosen.

(b)

82 82 82 82 82 $446,216 2 3 4 1.07 1.07 1.07 1.07 1.075 49 50 50 50 50 NPVP 240 $444,075 2 3 4 1.07 1.07 1.07 1.07 1.075 NPVT 110
The present value of the cost of the truck is -$446,216 and that of the pulley is $444,075. Hence the pulley should be chosen.

Instructors Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e 2009 Pearson Australia

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