Assignemnt 1

Question 1:
Joe Ferro's uncle is going to give him $250 a month for the next two years starting
today. If Joe deposits every payment in an account paying a nominal annual interest
rate of 6% compounded monthly, how much will he have at the end of three years?

Solution:
The accumulated blance in Joe's account is calculated from the following formula:
Balance = (Deposit)[ (1 + i)^n - 1 ] / i
where i is the periodic interest rate (annual interest divided by the number of periods per
year)
and n is the number of periods.
With Joe receiving $250 per month, at an annual interest rate of 6% compounded 12 times
per year (monthly), the accumulated balance after 2 years (24 months) is:
Balance = ($250)[ (1 + 0.06/12)^24 - 1 ] / (0.06/12)
Balance = (250)(0.12716) / 0.005
Balance = 6,357.99
Assuming that the part asking how much he has at the end of 3 years is not a typo, then Joe
leaves this balance in the account, where it accrues interest only for an additional 12
months.
The total at the end of the third year is then:
Balance = (6357.99)(1 + 0.06/12)^12
Balance = (6357.99)(1.005)^12
Balance = 6,750.14
Joe will have $6,750.14 at the end of the three years.
Question 2:
Question 3:
Question 4:
Question 5:

Question 6:
Question 6:
Question 7:
A paper company invests $4m to clear a tract of land and plant some young pine trees.
The trees will mature in 10 years, at which time the forest will have a market value of
$8m. What is the expected rate of return for the paper company's investment?

r = 7.18%.

Question 8:
Your firm is considering two investment projects with the following patterns of expected
future net after-tax cash flows:

1 $1 million $5 million

2 2 million 4 million

3 3 million 3 million

4 4 million 2 million

5 5 million 1 million

The appropriate cost of capital for both projects is 10%.

If both projects require an initial outlay of $10 million, what would you recommend
and why?
 Assignemnt 2
Question 1
Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year
for 5 years. The required return is 9% and required payback is 4 years.

 What is the payback period?

 What is the NPV?

 B/C ratio

 Should we accept the project?

Quick Quiz Chapter 8

r= 9%
Req. PB = 4 yrs

Cumulatve Cumulative
t CF CFs DCF DCFs
0 (100,000.00) (100,000.00) (100,000.00) (100,000.00)
1 25,000.00 (75,000.00) 22,935.78 (77,064.22)
2 25,000.00 (50,000.00) 21,042.00 (56,022.22)
3 25,000.00 (25,000.00) 19,304.59 (36,717.63)
4 25,000.00 0.00 17,710.63 (19,007.00)
5 25,000.00 25,000.00 16,248.28 (2,758.72)
(2,758.72)

Payback = 4 years

NPV = ($2,758.72) =NPV(E3,C9:C13)+C8

IRR = 7.93% =IRR(C8:C13)
Question 2:

Calculate the NPV for the two projects if the discount rate is 7%.

Project C0 C1 C2 C3 NPV @ 7%

Faster $(800) $350 $350 $350 $118.50

Slower $(700) $300 $300 $300 87.30

Solution
 Both projects have a positive NPV, thus both are acceptable. However, you
cannot do both of the these projects!
 Since the faster system would make a greater contribution to the value of
the firm, it should be your preferred choice.

Question 3:

Calculate Equivalent Annual Cost Cash Flows in Dollars

Project C0 C1 C2 C3 NPV @ 6%

Machine D 15000 4000 4000 4000 $25.692.5

Solutions

 The equivalent annual cost is calculated as follows:

 Equivalent Annual Cost = PV of Costs / Annuity Factor
 = $25,692.5 / 3 Year Annuity Factor
 = $25,692.5 / 2.673
 = $9,611.5 per year
 Question 4:

Question 5:

Hollow Truth Publishers is considering whether to launch a new e-magazine. The annual rate of return on a similar risk
project is 8%, the cash flows occur semi-annually (at the end of the 6th and 12th month), and the publishing company requires
a payback period of 2 years. The finance department has calculated that the required rate of return for all projects that it
will consider is 14%.

The costs of the project are:

Advertising on various billboards and cable television stations $210,000
Hollow Truth’s accounting department set up charges $ 50,000
Production costs and employee bonuses $250,000
Last years purchase price for the e-magazine's offices $470,000
Potential rental income from the offices if rented to a 3rd party $200,000

a. What are the total relevant costs of the project?

Advertising $210,000
Production costs $250,000
Potential Rents $200,000
-------------
Total $660,000

The accounting department charges are allocated overhead and last year’s purchase price is a sunk cost.
 b. Assume the semi-annual cash inflows are $150,000 and $200,000 in year 1, and $250,000 and
$200,000 in year 2. Calculate the payback, discounted payback, BCR, IRR and MIRR of the project. Based on
each criterion, should you accept the project? Why?

The accumulated cash flows at the end of the third period are $600,000 and $800,000 at the end of the
fourth period. Payback for the project will occur between the third and fourth cash flows (the first and last cash
flow in year 2).
Total costs are $660,000
Payback = 1.5 yrs+[(660,000 – 600,000)/200,000]*0.5 yrs = 1.65 years
Accept because it is paid back in the pre-specified period, 2 years.

The discounted accumulated cash flows at the end of the third period are $551,391 and $722,352 at the
end of the fourth period. Discounted Payback for the project will occur between the third and fourth cash flows
(the first and last cash flow in year 2).
Total costs are $660,000
Payback = 1.5 yrs+[(660,000 – 551,391)/170,961]*0.5 yrs = 1.82 years
Accept because it is paid back in the pre-specified period, 2 years.

Benefit to Cost Ratio (BCR) is the sum of the present value of the cash inflows divided by the present value of
the cash outflows.
BCR = (144,231+184,911+222,249+170,961)/660,000 = 1.09
Accept because the BCR is greater than 1.

IRR is that r which makes the NPV equal to 0. Remember IRR is solved by iteration. If you are doing
IRR by hand, you need to use trial and error to find IRR. Alternatively, your financial calculator probably has an
IRR function and Excel has an IRR function. Since these cash flows are semi-annual, the computed r is semi-
annual. So the annual IRR is 16.06% ((1.0773^2) – 1).

0 = -$660,000 + (150,000)/(1+IRR)1 + (200,000)/(1+IRR)2 + (250,000)/(1+IRR)3 + (200,000)/(1+IRR)4

Solve for IRR, IRR=0.0773
Since the finance department requires a 14% return, you would accept this project (16.06%>14%)

Since the IRR is 16% while the appropriate r is only 8%, IRR overstates the expected return due to the re-
investment rate assumption. In other words, IRR assumes that all the intermediate cash flows are re-invested at
16%. MIRR solves that problem by assuming that the intermediate cash flows are re-invested at an r that is closer
to the appropriate r which is 8%. The semi-annual MIRR is 6.37% while the annual rate is 13.15% ((1.0637^2)-
1).
PV(outflows) = -660,000 (in period 0 dollars)
FV(inflows, period 4 dollars) = 150,000*(1.04^3) + 200,000*(1.04^2) + 250,000*(1.04^1) + 200,000*(1.04^0)
= 845,050

MIRR = {[FV/PV] ^ (1/T)} -1 = {[845,050/660,000] ^ (1/4)} – 1 = 0.0637

Since the finance department requires a 14% return, you would reject this project (13.15%<14%)

c. If the project is analyzed using the NPV (net present value) rule, should you accept the project?
Why?
 What is the appropriate discount rate? Absent any other information, assume the compounding period of
the given rate is the same as the cash flows. So in this case, it is 8% compounded semi-annually.
T
CFt
NPV =  rsemi-annual = .04
t 1 (1  r )
t

NPV = -$660,000 + (150,000)/(1.04)1 + (200,000)/(1.04)2 + (250,000)/(1.04)3 + (200,000)/(1.04)4

NPV = $62,352 Therefore, accept the project because NPV > 0.

If there is a high degree of uncertainty about the semi-annual cash flows the first question that needs to
be addressed is did you pick the correct r. In this case, assume you have the correct r and instead the
uncertainty comes from whether you have the correct estimated cash flows. In that case you should do a
scenario analysis which includes assigning probabilities to each cash flow outcome and re-estimate NPV.

d. If you were the CEO of the firm, would you accept or reject this project? Why?

All of the other methods have various advantages and disadvantages but in the end, you want to focus on
NPV because it is the only method that always is consistent with maximizing shareholder wealth. Therefore you
want to accept this project because the NPV>0. Note that IRR and MIRR should be consistent with NPV in this
case because the cash flows are conventional and the project is independent. However, the finance department
has established a hurdle rate (14%) that does not reflect the riskiness of the cash flows so these two methods may
lead to sub-optimal decisions.