PRACTICE 5.

FINANCING EXERCISES
AND INVESTMENT

1. The company OSOPANDA, S.L. is considering making an investment, for which it has
two offers. The first offer (project A) involves an outlay of €16,653 and
guarantees cash flows of €6,500 and €13,000 in the first and second year respectively.
the investment, respectively. The second offer (project B) involves an outlay
much greater, at €71,428, but it will only last for one year, at the end of which you will obtain
a cash flow of €76,428.
With this data, you are asked to answer the following questions in a justified manner:
a) Indicate which offer the company will choose if it follows the period criterion.
recovery or payback.
b) Study the level of interest of each of the offers based on the cost of
capital opportunity and the Fisher Rate.

a) Según el criterio del periodo de recuperación, se optaría por el proyecto B, ya es éste

It has less than 1 year of payback period, while A requires over a year.
(not even two years old).
b) Calculation of the IRR for each project:
TIR (A) = 0.101
TIR (B) = 0.070
Calculation of the opportunity cost for which NPV (A) = NPV (B); i = 0.0507à Fisher Rate

VAN

Project b

Project to

5% 7% 10% i

A company wants to launch a product to the market and needs to make an investment.
for a new plant. The project will take 3 years and the following information is
available
The investment amounts to €250,000
A production level of 10,000 units is expected along with an increase in the
production of 10% over the previous year in each of the next two years
The cost of raw materials is €15 per unit.
 Additional workers need to be hired, which represents an annual cost of
30,000€.
Likewise, a maintenance contract for the machinery will be signed with a cost
from 3,000€/year, and a new warehouse will be rented for a cost of 10,000€/year
The company estimates that it will be able to sell the machinery at the end of the three years, for
15,000€.
The cost of capital is 6%. Using this data, respond:
a) What is the minimum price at which the products must be sold for the
Is the project profitable?

Establish without performing operations, how the following facts affect:

b) If the interest rate increases above 6%, how will it affect the minimum price?
For sale? And its current net value? And its IRR?
c) If there is a technical problem and production capacity can only increase by one
5% per year, how will this affect the minimum selling price? And its current value?
net? And its IR?

a)-250000+p*10000-15*10000-43000+p*11000-15*11000-43000+p*12100-15*12100-43000+15000=0
1.06 1.06 squared 1.06 raised to the power of 3

P=27 €

b) The minimum price will be higher as it will be affected by a higher interest rate. The NPV
It will fall. If the price given in section a) is the one applied, the IRR will remain the same (6%), and it will be higher.
that 6% if the new price is applied.

c) In this case, the selling price will also be higher to cover fixed costs when there is a
lower production. The NPV increases and the IRR falls.

3. The executives of a company have to decide between two investment projects.

whose cash flows (in thousands of euros) are shown in the following table:
Project Year 0 Year 1 Year 2
A -18.658 23.614 3,500
B -10,000 5,000 13.500

Considering that the cost of capital is unknown, which investment is preferable?

according to the methods of valuation of the payback period, internal rate of return
internal rate of return (IRR) and net present value (NPV)?

RECOVERY PERIOD:
Project A: It recovers in a year, as after the disbursement of 18,658 monetary units, at the end
From the first year, he perceives 23,614 monetary units, so he will recover the 18,658 disbursed from the current moment.
The recovery period is 1 year.
Project B: It is recovered at the end of year 2, as the disbursement of 10,000 units is not recovered with the
5,000 monetary units of the net cash flow of year 1, with 5,000 monetary units pending to be received along with
another 8,000 units at the end of year 2 (13,000 units).

The payback period is two years. Project A is preferred over B according to this criterion, because the
The recovery period of A is shorter than that of B.

TIR
From the quadratic equation, a single positive real root is obtained, which is the IRR of project A, rA =
39.96478213%. Project A will be profitable as long as the cost of capital, k, is less than that.
39.96478213%

From this quadratic equation, a unique positive real root is obtained, which is the IRR of project B.
rB= 40’84230634%. The project A will be profitable as long as the cost of capital, k, is less than that.
40’84230634%
According to the IRR criterion, project B would be chosen for having a higher rate of return, rB > rA.

VAN:
As the discount rate is unknown to calculate the NPV of the two projects, it will be analyzed
for what values of k the projects are indifferent according to the NPV, as that way it will be known for
What values of k make project A preferable to B and vice versa? The discount rate, k (cost of capital)
It will be obtained by equating the NPV formulas of the two projects.

From this quadratic equation, two positive real roots are obtained. The solution to this equation,
They are a Fisher rate, rf.
The obtained solutions are two:
rf1= 5,1787765% y rf2= 9 ,8131385%.

If 0≤k < rf1, VANB> VANA, project B will be chosen. The NPV for k=0% is 8,456 monetary units, while
that the NPV (0) = 8,500 monetary units.

If k = rf1, the projects are indifferent according to the NPV.

If rf1 < k < rf2, VANA > VANB, project A will be chosen.

If k = rf2, VANB = VANA, the projects are indifferent.

If rf2 < k, VANB > VANA, project B is chosen again.

4. A company wants to pay off a debt it has incurred in advance.

contract figure that must make two payments (capital + interest), one of €300,000 and
another of €500,000 within 5 to 8 years, respectively. Their intention is to liquidate the
debt in advance in two equal payments to be made at the end of the first and the
second year. What would be the amount of these payments if the interest rate applied
Is the interest on the loan 6%?

X X €300.000 €500.000

0 1 2 3 4 5 6 7 8

In order to verify the conditions of the problem, it must be made equivalent:

X + X / (1 + 0.06) = 300,000 / (1 + 0.06)4+ 500,000 / (1 + 0.06)7à X=293,381.58

It is observed that when comparing two situations, the calculation could be

simplifying it by referring to moment (1) instead of moment (0). If the calculation were to be carried out
Regarding the moment (0), each of the terms would be divided by another (1+0.06) and the
the result would be identical.

5. The financial director of the company Lavamax SA, dedicated to distribution and sales
The home appliances department receives the following proposal from a washing machine manufacturer:
Our usual payment formula is to receive the amount for the goods that
os vendemos, a 90 días desde su entrega. Pero en atención a que vuestro pedido
It is very interesting (€500,000), we can give you a 3% discount on it.
invoice, if we collect the payment in cash (discount for prompt payment)
Lavamax only has in cash the money necessary for small expenses.
but she has an open line of credit with her bank, for which the entity
The financial institution is charging a 0.2% annual fee (whether or not the money is used). The type of
the interest that the bank charges on the amounts withdrawn is 4.2% per year
(this cost includes the aforementioned line of credit).
What decision should the financial director make?

SAVINGSà 3% of 500,000 euros = 15,000.00 euros

ADDITIONAL COST for using the bank loanà
Interest rate: 4.2% -0.2% = 4% annually (the 0.2 is charged whether you withdraw money or not).
Cost of money for anticipating payment 3 months (1/4 year)à 4/4 = 1%
The full €500,000 is not needed, since they reduce €15,000, the amount required is:
485.000 €
Cost of using the credit for 90 days (0.01 x 485,000) = €4,850

RESULT. The saving by paying in cash and asking for credit: 15,000 - 4,850 = 10,150 €
The financial director will opt to pay in cash by obtaining the money from the credit account.

6. The opening of a bus service from Lorca to Madrid airport,

requires the acquisition of a minimum of 2 buses that are fully equipped,
they assume a total investment of 1,000,000€, with a useful life of 4 years. Each bus
It has 60 passenger seats, with a price per trip of €25. The variable cost
The fare for each route is €500. Each bus will make two routes a day, one outbound and one return.
back, every day of the year.
The expected average occupancy is 50% in the first year, 60% in the second, 70% in the third.
and 80% the fourth year.

1. What is the Net Present Value of the Lorca-Madrid Airport line, for a
forecast of the cost of money at 10%?
2. Expects to recover the invested money within a maximum period of 3 years; according to the
projections, will it achieve it? (quantify the answer).
Note: consider that the year has 360 days.
Solution
HYPOTHESIS / PERIOD Initial year 1 year 2 year 3 year 4
Inversion 1,000,000
buses 2
maximum passengers/bus 60
day trips / totals 2 1440 1440 1440 1440
occupation 50% 60% 70% 80%
Nº Viajeros 43,200 51.840 60.480 69.120
Traveler price/INCOME 25 1.080.000 1.296.000 1.512.000 1.728.000
COSTES/trayecto /total año 500 720,000 720,000 720,000 720,000
NET CASH FLOW 360,000 576,000 792.000 1.008.000
CASH FLOW DISCOUNTED AT 10% -1,000,000 327.273 476.033 595.041 688.478
VAN 1.086.825

PAY BACK -64.000 66000 -0.96969697 YES, IT RECOVERS IN 2 YEARS AND 1 MONTH

7. In an investment project that is intended to be carried out in four years for the purchase
For machinery, the following information is available:
Initial investment of €125,000.
The net income generated by the production of machinery during those
four years, are respectively €45,000, €55,000, €40,000, and €35,000.
A contract is established for the maintenance of the machinery, for an amount of
3,000€/year. Additionally, in the second year the machinery suffers a breakdown.
which is not provided for in the maintenance contract and the repair has a
additional cost of €2,000.
The machinery at the end of its 4-year useful life is sold for scrap for
10.000€.
The annual discount rate is 10%.
a) Calculate the NPV of the project
b) Reason (it is not necessary to calculate the value) how the following facts would affect:
1. If a discount rate equal to its Internal Rate of Return were considered
The IRR would be greater than, less than, or equal to 10%?
2. If the cash flows were the same but delayed by one year each, similarly
What would happen to the NPV and the IRR if the useful life of the machinery changes?
3. If the project were required to have a payback of less than 3 years, would it be met?
4. If there were a residual value at the conclusion of the project, how does it affect you?
VAN?
a) VAN = -125 + (45-3)/(1+0.1) + (55-3-2)/(1+0.1)² + (40-3)/(1+0.1)³ + (35-3+10)/(1+0.1)⁴ =
10989 €
 b.1) If the discount rate is equal to the IRR, the NPV is 0. Since the NPV is positive, the IRR
It must be greater than 10% (it is 14.06%).

b.2) There would be a decrease in NPV and IRR, since the present value of the flows
futures would be reduced by having to wait more years. Here the reduction is quantifiable: the
The NPV would become negative (-1373.22 €) and the IRR would be below 10% (9.64%)
b.3) That's right, the payback of the project is 2 years and 7.5 months.

Having a positive cash flow in the last year increases the NPV.

8. What is the maximum amount we should invest in a project at time 0?

if the estimated cash inflows are 30,000 euros per year for 4
years from the year 1? It has been estimated that the internal rate of return is 8%.

Knowing that the IRR is the rate (I=K) that makes the NPV equal to 0. We solve for it.

30.000 30.000 30.000 30.000

VAN= −I 0+ + + + = 0⇒ I 0= 99.363,81
1.08 1.082 1.083 1.084

I 0= 99,363.81 it is the maximum amount of investment

9. The cash flows of two investments are:

0 1 2
A -1000 1000 1000
B -100000 65000 65000

k = 13%

1. Comment on the result of calculating NPV and IRR

2. Draw the graph of NPV and IRR for different values of k. Comment on whether it exists.
Fisher's intersection and its effect.
Solution
VAN TIR
A 668.1 61.80%
B 8,426.7 19.43%

Tasa de Fisher = 18,98%

K>18.98àB
18.98 < K < TIRBà B
>TIRBàA
10. Two projects A and B have a Fisher rate of 5% and the IRRBTIRA. The
the investor must choose one of the two projects (assumption: linear and decreasing NPV)
regarding the interest i, for both projects). Answer the following questions:
a) Which project is better for: Fisher rate < i < IRRB?
b) Which project is better for: i< Fisher rate?
c) Which project is better for: IRRB< i< TIRA

Graphically:
a) Project A
b) The Project B
c) The Project A

VAN

Project b

Project to

i
5% TIRB