ACF 103 – Fundamentals of Finance
Tutorial 8 - Solutions
Chapter 13
1.
Your firm is considering two mutually exclusive projects, code-named A and
B, that would each require an initial cash outflow of $10,000. They would
generate the following incremental, after-tax, operating cash flows:
Project A
$5,000
4,000
3,000
Year 1
Year 2
Year 3
A.
B.
C.
* D.
Project B
$3,000
4,000
6,000
If the firm's required rate of return is 14%, which would you select?
Project A because it has the shorter payback period.
Project A because it has the higher net present value.
Project B because it has the higher internal rate of return.
Neither project because neither adds value to the firm.
Proof:
Project A CF
Year )
-$10,000
Year 1
$5,000
Year 2
4,000
Year 3
3,000
Net Present Value
PVIF14%,3
1.0000
0.8772
0.7695
0.6750
PV
Project B CF PVIF14%,3
PV
-$10,000 -$10,000
1.0000
-$10,000
4,386
$3,000
0.8772
2,632
3,078
4,000
0.7695
3,078
2,025
6,000
0.6750
4,050
-511
-240
2.
A strip mine will have an initial cash outflow of $25 million and expected
after-tax, operating cash inflows of $5 million per year over its 10-year
economic life. However, the Environmental Protection Agency requires repair
and replanting of mined areas every five years. This will result in additional
after-tax outflows of $6 million in years five and ten. Based on this scenario,
which of the following statements is true?
A.
The project's payback period is five years.
B.
The value of this project today can be calculated as the sum of the cash
inflows minus the cash outflows.
C.
A profitability index cannot be calculated for this project because there are
negative cash flows in some years.
* D. This project may have more than one internal rate of return.
3.
A firm is considering two mutually exclusive investment alternatives, both of
which cost $5,000. The firm's hurdle rate is 12%. The after-tax cash flows
associated with each investment are:
Year
1
2
3
4
Investment A
$2,000
1,500
1,500
1,000
Investment B
$1,000
1,500
2,000
3,000
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For each alternative, calculate the payback period, the net present value, and
the internal rate of return. Which alternative (if any) should be selected?
Answer:
Alternative A:
Payback: $2,000 + $1,500 + $1,500 = $5,000 (3 years)
NPV at 12% = ($2,000)(0.893) + ($1,500)(0.797) + ($1,500)(0.712) +
($1,000)(0.636) - $5,000
= -$314.50
IRR = 8.6%
Alternative B:
Payback: $1,000 + $1,500 + $2,000 + $500 = $5,000
(3 + 500/3000 = 3.167 years)
NPV at 12 percent = ($1,000)(0.893) + ($1,500)(0.797)
+ ($2,000)(0.712) + ($3,000)(0.636) - $5,000 = $420.50
IRR = 15.3%
Option B is the BEST alternative as it INCREASES shareholder wealth.
4.
The Cardinal Machine Tool Company is considering the purchase of a new
drill press to replace the one currently being used. The present machine is
expected to last another seven years and have no salvage value. The drill press
in current use has a book value of $700 and can be sold today for $400.
Cardinal pays $300 a year maintenance on the press. The new drill press will
cost $1,500. It is expected to last seven years, at which time it will be sold for
$100. The maintenance cost of the new machine is expected to be $150 a year.
Cardinal depreciates its assets on the straight-line basis and pays 40% taxes. If
its opportunity cost of funds is 10%, should it buy the new machine?
Answer:
Initial cost = $1,500 - $400 + ($700 - $400)(0.40) = $980
Annual savings after tax
= ($300 - $150)(0.60)
= $90
Change in depreciation
= ($1,500 - $100)/7 - $700/7
= $100 per yr
Tax saving on depr. change
= ($100)(0.40)
= $40
NPV at 10% = ($90 + $40)(4.868) + ($100)(0.513) - $980 = -$295.86
Since the NPV is negative, we would REJECT this project at this time.
5.
A firm is considering the following projects, all of which are independent of
one another. Available funds are limited to $2 million in this capital budgeting
period, but future periods will have no capital budget constraints.
Present Value of
Project
Initial Outlay
Cash Inflows
1
$1,300,000
$1,200,000
ACF 103 HAUT 2014 Tutorial Solns
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2
3
4
5
6
7
8
1,000,000
800,000
600,000
500,000
400,000
300,000
100,000
1,250,000
900,000
700,000
550,000
470,000
280,000
105,000
Which projects should be accepted without exceeding the budget?
Answer:
Project Profitability Index
Cumulative Investment
2 1,250,000/1,000,000 = 1.25
$1,000,000
6
470,000/400,000 = 1.18
1,400,000
4
700,000/600,000 = 1.17
2,000,000
3
900,000/800,000 = 1.13
2,800,000
5
550,000/500,000 = 1.10
3,300,000
8
105,000/100,000 = 1.05
3,400,000
7
280,000/300,000 = 0.93
Reject
1 1,200,000/1,300,000 = 0.92
Reject
Projects 2, 6, and 4 should be accepted; they exhaust the budget.
6.
Text book Ch 13, problem # 8 (p.348)
Answer:
a.
Selecting those projects with the highest profitability index values would
indicate the following:
Project
Amount
PI Net Present Value*
1
$500,000
1.22
$110,000
3
350,000
1.20
70,000
$850,000
$180,000
* NPV =
(Amount x PI) - Amount
=
(500,000 x 1.22) – 500,000 = 110,000
However, utilizing “close to” full budgeting will be better.
Project
Amount
PI
Net Present Value
1
$500,000
1.22
$110,000
4
450,000
1.18
81,000
$950,000
$191,000
b.
No. The resort should accept all projects with a positive NPV. If capital is not
available to finance them at the discount rate used, a higher discount rate
should be used, which more adequately reflects the costs of financing.
ACF 103 HAUT 2014 Tutorial Solns
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