Professional Documents
Culture Documents
Business Finance
Assignment 2
Prepared by
Dr. Vincent Gr
egoire
Department of Finance
Faculty of Business and Economics
The University of Melbourne
Semester 1, 2016
Administrative Arrangements
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Questions
Question 1. Companies that use WACC as the required rate of return for all investment
projects, regardless of risk, will tend to:
a) Incorrectly reject high risk project.
b) Incorrectly accept high risk projects.
c) Incorrectly accept low risk projects.
d) Increase in risk and value over time.
Solution to Question 1: The correct answer is b.
For low risk projects, incorrectly using the WACC (higher than the actual required rate
of the project) can cause the firm to incorrectly reject low risk projects over time.
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For high risk projects, incorrectly using the WACC (lower than the actual required rate
of the project) can cause the firm to incorrectly accept high risk projects over time.
Over time, this will cause the firm to increase in risk and decrease in value.
Question 2. You are analysing an investment project with conventional cash flows (only
one sign change). Using the IRR method, you find that you are indifferent to accepting
the project or not. The NPV of the project is:
a) Negative
b) Positive
c) Zero
d) The project has no NPV.
Solution to Question 2: The correct answer is c.
Using the IRR method, the firm is indifferent to accepting the project or not when the
IRR is equal to the required rate of return. The IRR is the discount rate that makes the
NPV equals to 0, so this means the NPV of the project must be 0.
Question 3. A manufacturing company is trying to decide between the following two
mutually exclusive projects:, with their respective projected cash flows:
Year
Machine A
Machine B
-12,000
-18,000
6,500
8,500
6,000
9,000
7,000
9,500
The company requires that all accepted projects have a payback less than three years
and produce a minimum rate of return of 11%. What should the company do and why?
a) Project I should be accepted but Project II should be rejected because only Project I
satisfies the payback period requirement.
b) Both projects should be accepted because they have IRRs which exceed the 11% requirement.
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c) Both projects should be accepted because they both have positive NPVs.
d) Project II should be accepted because it has the highest NPV.
Solution to Question 3: The correct answer is d.
Project I has an NPV of $3,843, IRR of 28.45% and payback period of 1.91 years.
Project II has an NPV of $3,909, IRR of 22.87% and payback period of 2.05 years. Both
projects are acceptable individually under the NPV, IRR and payback period method.
Since the projects are mutually exclusive, the company should pick the project with the
highest NPV, which is project II.
Question 4. A firms capital structure is currently all debt and common stock. The firm
is worth $100M today and would like to raise another $20M by issuing preference shares
with a fixed $5 p.a. dividend in perpetuity. The cost of equity is 10%, after-tax cost of
debt is 7%, and the current after-tax WACC is 8%. What should be the minimum price
per preference share if the firm does not want to raise its after-tax WACC?
a) $4.00
b) $62.50
c) $71.43
d) They could issue at any price.
Solution to Question 4: The correct answer is b.
If the firm does not want to raise its WACC, the maximum value for the cost of preference shares is 8% (the current value for the WACC). Therefore the minimum share price
is
P0 = Dp /kp = $5/0.08 = $62.50.
Question 5. The NPV of an investment project with conventional cash flows is -$20,500.
Which of the following is/are true if the project is assigned a 10.20% required rate of return?
I. The project will have a negative IRR.
II. The initial investment is more than the market value of the project
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II. When comparing projects, the IRR will give the same decision as NPV when the
projects have the same lives.
III. If two projects have the same IRR, then they also have the same NPV.
a) I only.
b) II only.
c) I and III only.
d) I, II and III.
Solution to Question 8: The correct answer is a.
II is false because NPV and IRR can give conflicting results even if the projects have
the same lives (see Lecture 14.1).
III is false. If two projects have the same IRR, it means that the same discount rate
makes their NPV equal to 0, but it doesnt mean that their NPV at the required rate of
return will be equal.
Question 9. A company is considering two mutually-exclusive projects with the following
projected after-tax cash-flows (assume earnings and cash flows are the same):
Year
Project A
Project B
-$120,000
-$10,000
$90,000
$5,000
$10,000
$5,000
$10,000
$12,000
$45,000
$12,000
The required rate of return is 10% and the required ARR based on initial investment
is 40%. What should the company do according to the NPV and ARR methodologies?
a) Choose Project A according to both NPV and ARR.
b) Choose Project B according to both NPV and ARR.
c) Choose Project A according to NPV and project B according to ARR.
d) Choose Project B according to NPV and project A according to ARR.
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b) For a project with an initial outlay and positive future cash flows, using a nominal
discount rate with real cash flows will produce an incorrect NPV that is greater than
the true NPV.
c) For a project with an initial outlay and positive future cash flows, using a real discount
rate with real cash flows will produce an incorrect NPV that is lower than the true
NPV.
d) For a project with an initial outlay and positive future cash flows, using a nominal
discount rate with nominal cash flows will produce an incorrect NPV that is lower than
the true NPV.
Solution to Question 11: The correct answer is a.
If you use nominal expected cash flows with a real expected discount rate the NPV so
calculated will be higher than it should be as the discount rate does not discount the cash
flows for expected inflation even though the expected cash flows include expected inflation.
If you use real expected cash flows with a nominal expected discount rate then the NPV
so calculated will be lower than it should be since you discount the cash flows for expected
inflation in effect twice (once by lowering the expected cash flows by expected inflation to
get the real expected cash flows, then again when you discount by the nominal discount
rate which includes expected inflation).
If you use nominal expected cash flows with a nominal expected discount rate then the
NPV should be correct and be the same as if you use real expected cash flows with a real
expected discount rate.
Question 12. Assume that a firm is financed by 60 percent equity, 10 percent preference
shares and the remainder by debt. The corporate tax rate is 30 percent. The before-tax
costs of capital for debt, preference and equity capital are 6 percent, 12 percent and 18
percent, respectively.
The firm is considering three independent projects: projects A, B and C with IRRs of
10%, 12% and 14% respectively. These projects have conventional cash flows and the same
risk as the firms current operations. Which of these projects should it accept?
a) Only Project A.
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b) Only Project C.
c) Projects A and B.
d) Projects B and C.
Solution to Question 12: The correct answer is b.
The weight of debt in the capital structure of the firm is kd = 1kp ke = 1.1.6 = 0.3.
The after-tax WACC is :
k0 = kd (1 tc )(D/V ) + kp (P/V ) + ke (E/V )
= 0.06 (1 .3) 0.3 + 0.12 0.1 + 0.18 0.6
= 13.26%
Only Project C has an IRR greater than 13.26%, so the firm should only accept Project
C.
Question 13. The initial cost of a machine required for a project is $60,000. It has a
useful life of 10 years and will be depreciated on a straight-line basis over 10 years. The
machine is expected to generate before-tax operating cash flows of $10,000 per year life
and the effective corporate tax rate is 30%. The appropriate discount rate is 12% p.a.
after-tax. The company plans to sell the machine for $25,000 at the end of year 6. Which
of the following statements is true?
a) The project should be accepted because the NPV is $2,340.
b) The project should be rejected because the NPV is -$13,302.
c) Depreciation is irrelevant because it is not a cash flow.
d) The after-tax salvage value in year 6 is $24,700.
Solution to Question 13: The correct answer is d.
The NPV of the project is -$11,305.83, so a) and b) are false. Depreciation is not
irrelevant because it reduces taxes, so c) is false. The book value of the machine in year 6
is $60,000(1-6/10)=$24,000, so the gain is $25,00-$14,000=$1,000. The tax payable from
that gain is .3*$1,000=$300, so the total after-tax cash flow is $24,700.
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Year
Project A
Project B
-$60,000
-$30,000
$26,000
$10,000
$25,000
$12,000
$30,000
$17,500
$26,200
$11,600
$13,200
$8,450
The NPV and IRR methods must give conflicting decisions for these projects if:
a) The required rate of return is less than 31% pa.
b) The required rate of return is greater than 28% pa.
c) The required rate of return is between 28% pa and 31% pa.
d) None of the above.
Solution to Question 15: The correct answer is d.
Since the crossover point, which is 34%, is higher than both projects IRRs (31% and
28% respectively), the ranking would be different for required rate of returns higher than
34%. However, for required rate of returns higher than 34%, both projects have negative
NPV so the ranking does not matter, the NPV and IRR methods would reject the project.
Note: The crossover point can be found by computing the IRR of the differencial project
(A-B) or (B-A). (see lecture on incremental IRR).
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