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Corporate Finance
Tutorial 1: Time Value of Money and Project Appraisal
Suggested Solutions
Solutions to Exercises on Time Value of Money
A1.
(a)
i compounded annually
PV(Bid)
= PV(FB)
= $5,000,000 PVIF 20%,5
= $5,000,000 (0.4019)
= $2,009,500
(b)
i compounded semi-annually
PV(Bid)
(c)
i compounded quarterly
PV(Bid)
A2.
Method 1
$20,000 = (PMT) PVIFA 12%,5
PMT
$20,000
3.6048
Corporate Finance
Method 2
$20,000 = (PMT) PVIFA 1%,60
PMT
$20,000
45
Plan X
Yr
CF
75,000
Interest Factor
1
PV (CF)
75,000
1
2
7,500
PVIFA 3,10%
18,651.75
PVIF 3,10%
18,782.50
3
3
25,000
4
5
6
7
8
PVIFA 12,10%
9,000
x PVIF 3,10%
46,072.20
(15,000)
PVIF 15,10%
(3,591)
9
10
11
12
13
14
15
15
PV (Cost)
Impact Consultancy & Training Pte Ltd
$154,915.45
2
Corporate Finance
Plan Y
Yr
CF
Interest Factor
PV (CF)
30,000
4,500
PVIFA 5,10%
17,058.60
40,000
PVIF 5,10%
24,836
6,000
PVIF 6,10%
3,387
9,500
PVIFA 9,10%
x PVIF 6,10%
30,884.50
30,000
1
2
3
4
5
7
8
9
10
11
12
13
14
15
10
40,000
PVIF 10,10%
15,420
15
(30,000)
PVIF 15,10%
(7,182)
PV (Cost)
114,404.10
The revenue aspect of this project is assumed to be the same regardless of which plan is
adopted. Hence, the decision rest on which plan is effectively cheaper.
PV (Costs) of Plan Y < PV (Costs) of Plan X
Impact Consultancy & Training Pte Ltd
=>
Plan Y is preferred.
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A2.
A3.
A4.
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PV Factor
PV of CF ($)
(1,000,000)
1.0000
(1,000,000)
200,000
0.9091
181,820
190,000
0.8264
157,016
180,500
0.7513
135,610
171,475
0.6830
117,117
162,901
0.6209
101,145
154,756
0.5645
87,360
147,018
0.5132
75,450
140,000
0.4665
65,310
140,000
0.4241
59,374
10
140,000
0.3855
53,970
NPV
34,172
Corporate Finance
Corporate Finance
b)
c)
The assumptions on which the calculations in part (a) were based on are:
The assumption of a constant discount rate may not reflect the interest rate
risk. However, as it is not possible to predict future levels of interest rate with
pinpoint accuracy, it would be fair to assume constant given an existing
capital structure and the cost of its respective sources of capital provided the
risk of interest rate fluctuations is incorporated.
Although cash flows in a project usually occur evenly each year but to
simplify calculations they are assumed to occur at a particular point in time.
The end of the year assumption effectively only caused the calculation to be
more conservative.
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Corporate Finance
Give a rate of interest over the life of the project which can be compared
with the companys cost of capital.
In most accept/reject decisions, advice given by IRR will coincide with
that given by NPV. However, IRR has technical problems where there are
unconventional cash flows (multiple IRRs) and may give incorrect advice
where a choice has to be made between mutually exclusive projects.
IRR is often favoured over NPV in practice because, as mentioned above,
businessmen find it easier to relate to.
Payback rule
Measures how long (usually how many years) the project will take to pay
back the initial investment.
This method is often favoured by businessmen because it is claimed that it
emphasizes liquidity and makes an intuitive allowance for risk. It is also
simple to use and easy to understand.
However, use of payback alone can lead to the selection of unprofitable
projects.
No recognition is given to the time value of money.
Cash flows receivable after the payback period are ignored.
Risk is related to the speed of payback which may not be realistic.
The use of payback will tend to favour short-term projects, which may
lead to the adoption of unprofitable or low profit short-term projects and
the exclusion of long-term profitable ones.
Corporate Finance
AEV (Model A) =
AEV (Model B)
!
NPV 22.31
=
= 8.97
A3.10 2.4868
18.18
= 10.48
1.7355
Hence, if both models can be repeated in the foreseeable future, Model B is more
economical.
!
10
Corporate Finance
Cost of
machine
(1,200,000)
Expected annual
Contribution (1)
903,600
936,000
972,000
1,044,000
Modification
Cost (2)
_________
(50,000)
_______
_________
NCF before
tax
(1,200,000)
853,600
936,000
972,000
1,044,000
Tax (3)
__________
(166,080)
(213,300)
(240,975)
(161,325)
NCF
after tax
(1,200,000)
687,520
722,700
731,025
882,675
DF @ 15%
_________
0.870
0.756
0.658
0.572
PV (NCF)
(1,200,000)
598,592.40
546,361.20
NPV
481,014.45
504,890.10
$930,408.15
11
Corporate Finance
Note (1)
(i)
(ii)
(iii)
(iv)
8
6
20
(10)
24
60
(24)
36
Y2
Y3
Y4
25,100
26,000
27,000
29,000
36
________
36
_______
36
_______
36
_______
936,000
972,000
1,044,000
= 50,000
= 50,000
12
Corporate Finance
130,626.12 50,000
= 80,626.12
= 40,831.76 + 71,011.75
= 111,843.51
= 71,011.75
Capital Allowance :
0
Written Down
Value
1,200,000
900,000
675,000
506,250
Capital Allowance
(25%)
300,000
225,000
168,750
4___
506,250
13
Corporate Finance
(ii)
Tax Expense :
Pre-tax profit
Before Capital
Allowance
(b)
853,600
936,000
972,000
1,044,000
(225,000)
(168,750)
(506,250)
Pre-tax profit
After Capital
Allowance
553,600
711,000
803,250
537,750
Tax (30%)
166,080
213,300
240,975
161,325
14