FINM 2412 Financial Management for Business

Tutorial 6 Answers

Question 1
You are given the following information relating to a proposed capital investment:

Year 0 1 2 3 4

Net cash flow (after-tax) (7,000) 2,500 3,200 3,000 2,500

You are required to calculate the project’s:

(a) NPV

(b) IRR (Hint: try 21% and 22%)

(c) Payback period.

Under each method, explain whether or not the firm should accept the project. For
investments of this type, the firm’s risk-adjusted discount rate is 15% p.a. The cut-off for
payback period is 2 years.

(a)

Since the NPV is positive, we would proceed with the project.

2,500 3,200 3,000 2,500

NPV =−7,000+ + + + =$ 995.50
( 1.15 ) ( 1.15 )2 ( 1.15 )3 ( 1.15 )4

(b)

The IRR is the discount rate which makes NPV =0. Use trial and error:

Try 21% à NPV = +111

Try 22% à NPV = -20

A discount rate of 21% p.a. produces a NPV of +111. A discount rate of 22% p.a. produces a NPV of
–20. Therefore, the IRR is close to 22% p.a. Since the IRR is greater than the required return for the
project (15%), we would proceed with the project.

(c)

The project's payback period is 2.43 years. After two years, $5,700 has been “paid back”. Assuming
the $3000 in year 3 arrives evenly throughout the year, the remaining $1300 needed to payback the
initial cost will have arrived by 0.43 of the way through the year. Since the cut-off for payback (in this
case) is two years, the project would be rejected under the payback period method.

OR

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PB = Years to recover cost + Remaining cost to recover / Cash flow during the year

= 2 + (7000 – 2500 – 3200) / 3000 = 2.43 years

Question 2
Assume that a firm with a cost of capital of 10% p.a. must choose between two mutually
exclusive projects having net (after-tax) cash flows as shown below:

Project Initial Outlay Year

1 2 3

X -$10,000 $7,000 $4,000 $2,000

Y -$10,000 $2,000 $4,000 $8,200

(a) Using the NPV method, which project is preferred?

(b) Using the IRR method, which project is preferred? (Hint: for project X, try 18.2% and
21.1%; for project Y, try 13.3% and 15.8%)

(a)

7,000 4,000 2,000

NP V A =−10,000+ + + =1,172
( 1.10 ) (1.10 )2 ( 1.10 )3

2,000 4,000 8,200

NP V B=−10,000+ + + =1,284
( 1.10 ) ( 1.10 )2 ( 1.10 )3

Since NPV Y > NPV X , and NPV Y >0 , we would choose to proceed with Project Y.

(b)

Using a financial calculator, spreadsheet or trial and error, we can compute the IRR for each project
as:

IRR X =18.2 % p . a .

IRRY =15.8 % p . a .

In both cases, the IRR exceeds the required return on the project of 10% p.a. So, each project is
acceptable in its own right. If we were basing our decision solely on IRR, Project A has the higher IRR
and would be preferred.

In this case, the IRR incorrectly ranks the projects. Project Y has the greater effect on firm value (as
measured by NPV) and should be selected. The IRR technique favors project with cash flows early in
their lives. In this case, Project X generates large cash flows much earlier than Project Y.

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Question 3
Use the data on Projects X and Y from Question 2 (above).

Management seeks to measure the sensitivity of the net present value to variations in the
cost of capital. To provide such analysis, prepare a single graph showing NPV profiles of
both Projects X and Y. Completing the table below may help.

NPV at various discount rates

0% 5% 10% 15% 20% 25%

X 7000+40
00+2000
-10000

Y 2000+40
00+8200
-10000

(a) Where do the two NPV profiles cut the x-axis? What do these figures represent?
(b) At what point (roughly) do the NPV profiles intersect? How can we interpret this
point?
(c) From the graph, which project is preferred at the firm’s 10% risk-adjusted discount
rate? What if it was 15%? What if it was 20%?

NPV at various discount rates

0% 5% 10% 15% 20% 25% 30%

X 3,000 2,022 1,172 427 (231) (816) (1,338)

Y 4,200 2,616 1,285 155 (810) (1,642) (2,362)

NPV Profile
5,000

4,000

3,000

2,000
NPV ($)

1,000 Project X

0 Project Y
0% 5% 10% 15% 20% 25% 30% 35%
-1,000

-2,000

-3,000
Discount Rate (%)
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(a)

The NPV profiles for Projects X and Y at the axis at 18.2% and 15.8%, respectively. These figures
represent the IRR for each project; the discount rate which makes NPV = 0.

(b)

The NPV profiles intersect at about 11.4% p.a. At this discount rate, we would be indifferent between
the two projects.

(c)

At a 10% discount rate, NP V Y > NP V X , so we prefer Project Y. At 15%, NP V X > NPV Y so we

prefer X. At 20%, both projects show a negative NPV so we would not want to invest in either.

Question 4
Kalorie Cola is considering buying a special-purpose bottling machine for $28,000. It is
expected to have a useful life of 7 years with a zero disposal price. The plant manager
estimates the following savings in cash-operating costs:

YEAR AMOUNT

1 $10,000

2 8,000

3 6,000

4 5,000

5 4,000

6 3,000

7 3,000

Total $39,000

The Plant Manager argues that, since the total cash savings ($39,000) exceed the outlay
($28,000), Kalorie Cola should definitely purchase the machine.

(a) Calculate whether the bottling machine should be purchased according to the
following methods: (i) net present value (NPV), and (ii) internal rate of return (IRR)
(Hint: try 13%, 12% and 11%). Kalorie Cola’s required rate of return is 16% p.a.

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 (b) Explain to the Plant Manager why his logic for purchasing the machine is flawed.
Why can't we compare the total cash savings with the machine cost?

(a)

Since NPV < 0, we would not proceed with the project.

10,000 8,000 6,000

NPV =−28,000+ + +
1.16 (1.16)2 ¿ ¿ ¿−$ 2,631

The IRR is calculated by trial and error:

 at 13%, NPV = -$773

 at 12%, NPV = -$99

 at 11%, NPV = +$605.

Thus, IRR is between 11% and 12%. Since this IRR is less than the required return of 16% p.a., we
would not proceed with the project.

(b)

The $28,000 outlay must be made today, whereas the $39,000 cash inflow occurs in ‘lumps’ over the
next 7 years. We can’t compare these directly – we must find the present value of all cash flows. Put
another way, suppose we borrow $28,000 at 16% to finance the project. The projects cash inflows
over the next seven years would be insufficient to pay off this loan.

Question 5
UQ Business School Pty Ltd designs a range of eye-catching fluorescent t-shirts. The
designers have always hand-drawn and painted their new fashion ranges. The new head
of the Business School is considering purchasing a new computer-aided design (CAD)
package to allow her designers to create their designs on computers. The CAD project is
expected to generate cost savings by improving productivity. Also, UQBS can submit
electronic templates of its latest designs to the manufacturers of its fashion ranges, which
would also make significant savings. The upfront hardware and software costs to UQBS is
estimated at $300,000. The computers and software have a 5-year useful life. After that,
the technology will be obsolete and will have no salvage value. The CAD project is
expected to save UQBS approximately $88,000 (after tax) per annum.

Advise the new head on the acceptability of the CAD proposal, applying the following
capital budgeting methods:

(a) Net Present Value

(b) Internal Rate of Return (Hint: try 13%, 14% and 15%)

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 Assume that all cash flows occur at the end of each period, with the exception of the
upfront outlay, which is paid at the commencement of the project. Assume that UQBS’s
required rate of return on this project is 10%.

NPV is relatively easy to calculate since the after-tax cash flows are annuity.

(a)

Since NPV > 0, we would proceed with the project.

( )
−5
1−( 1.10 )
NPV =−300,000+88,000 =$ 33,589
0.10

(b)

IRR can be calculated by trial and error:

 at 13%, IRR = +9,516

 at 14%, IRR = +2,111

 at 15%, IRR = -5,010

Thus, the IRR is between 14% and 15%. Use a financial calculator or a spreadsheet program to get a
more precise answer if you choose. Since the IRR exceeds the 10% required return, we would
proceed with the project.