Business Finance II: Exercise 1

Business Finance II
Exercise 1
1. In statistics, you learn about Type I and Type II errors. A Type I error occurs when a statistical test
rejects a hypothesis when the hypothesis is actually true. A Type II error occurs when a test fails to
reject a hypothesis that is actually false. We can apply this type of thinking to capital budgeting. A
Type I error occurs when a firm rejects an investment project that would actually enhance shareholder
wealth. A Type II error occurs when a firm accepts a value-decreasing investment, which should have
been rejected.
a) Describe the features of the payback rule that could lead to Type I errors.
b) Describe the features of the payback rule that could lead to Type II errors.
c) Which error do you think is more likely to occur when firms use payback analysis? Does your
answer depend on the length of the cutoff payback period? You can assume a “typical” project
cash flow stream, meaning that most cash outflows occur in the early years of a project.
2. In what way is the NPV consistent with the principle of shareholder wealth maximization? For a
firm that uses NPV rule to make investment decisions, what consequences result if the firm
misestimates the shareholders’ required returns and consistently applies a discount rate that is “too
high”?
3. A particular firm’s shareholders demand a 15% return on their investment given the firm’s risk.
However, this firm has historically generated returns in excess of shareholder expectations, with an
average return of 25%.
a. Looking back, what kind of stock price performance would you expect to see for this firm?
b. A new investment opportunity arises, and the firm’s financial analysts estimate the project’s
return will be 18%. The CEO wants to reject the project because it would lower the firm’s
average return and therefore lower the firm’s stock price. How would you respond?
4. Suppose that a project has a discounted payback period equal to the life of the project (assuming a
10% discount rate). What is the NPV of the project, and what is the IRR?
5. Investec International is considering investing in two assets – A and B. The initial outlay, annual
cash flows, and annual depreciation for each asset are shown in the table below for the assets’ assumed
five-year lives. As can be seen, Investec will use straight-line depreciation over each asset’s five-year
life. The firm requires a 12% return on each of those equally risky assets. Investec’s maximum payback
period is 2.5 years, maximum discounted payback period is 3.25 years, and its minimum accounting
rate of return is 30%.
Initial Outlay Asset A ($ 200,000) Asset B ($ 180,000)

Year CF Depreciation CF Depreciation
1 70,000 40,000 80,000 36,000
2 80,000 40,000 90,000 36,000
3 90,000 40,000 30,000 36,000
4 90,000 40,000 40,000 36,000
5 100,000 40,000 40,000 36,000
Using the calculations for accounting rate of return, payback period and discounted payback period,
suggest which asset should be invested in?
6. Erwin Enterprises has 10 million shares 10%. Given this information, determine the
outstanding with a current market price of $ 10 impact on Erwin’s stock price and firm value if
per share. There is one investment available to the capital markets fully reflect the value of
Erwin, and its cash flows are provided in the undertaking the project.
table below. Erwin has a cost of capital of
Year Cash Flows
0 -10,000,000
1 3,000,000
2 4,000,000
3 5,000,000
4 6,000,000
5 9,800,000
7. Contract Manufacturing, Inc. is considering

two alternative investment proposals. The first
proposal calls for a major renovation of the
company’s manufacturing facility. The second
involves replacing just a few obsolete pieces of
equipment in the facility. The company will
choose one project or the other this year, but it
will not do both. The cash flows associated
with each project are presented in the table
below and the firm discounts projects at 15%.
Cash Flows
Year Renovate Replace
0 -9,000,000 -1,000,000
1 3,500,000 600,000
2 3,000,000 500,000
3 3,000,000 400,000
4 2,800,000 300,000
5 2,500,000 200,000
a. Rank these investments based on their NPVs

b. Rank these Investments based on their IRRs
c. Who do these rankings yield mixed signals?
d. Calculate the IRR of the Incremental Project. Reconcile your answer to this question with
those from parts (a) and (b)
8. A certain firm has the following stream of cash flows:
Year Cash Flows

0 17,500
1 -80,500
2 138,425
3 -105,455
4 30,030
a. Fill in the following table:
Discount Rate NPV

0
5
10
15
20
25
30
35
50
c. Use the table in (a) to plot the NPV profile.

d. What is the project’s IRR?
e. Describe the conditions under which the firm should accept this project.
9. Both ‘Old Line Industries’ and ‘High Tech, Inc.’ use the IRR to make investment decisions. Both
firms are considering investing in a more efficient $ 4.5million mail-order processor. This machine
could generate after-tax savings of $ 2 million per year over the next 3 years for both firms. However,
due to the risky nature of its business, High Tech has a much higher cost of capital (20%) than does
Old Line (10%). Given this information, answer the following questions:
a. Should Old Line invest in this processor?

b. Should High Tech invest in this processor?
c. Based on your answers in the above questions, what can you infer about the acceptability of
projects across firms with different costs of capital?
10.
JK Products, Inc. is considering investing in Working with the accounting and finance
either of two competing projects that will personnel, the firm’s CFO developed the
allow the firm to eliminate a production following estimates of the cash flows for the
bottleneck and meet the growing demand for alternatives. The firm has an 11% required
its products. The firm’s engineering return and views these projects as equally
department narrowed the alternatives down to risky.
two – Status Quo (SQ) and High Tech (HT).
Cash Flows
Year SQ HT
0 -670,000 -940,000
1 250,000 170,000
2 200,000 180,000
3 170,000 200,000
4 150,000 250,000
5 130,000 300,000
6 130,000 550,000
a) Calculate the NPV of each of the project, assess its acceptability and indicate which project is
best.
b) Calculate the IRR and make recommendations on which alternative the firm should accept
c) Calculate the PI and analyze the result
d) Draw the NPV Profile for project SQ and HT on the same set of axes and use this diagram to
explain the differences between the results from the two most popular capital budgeting
techniques.
e) Which of the two projects would you recommend and why?

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Business Finance II

Initial Outlay Asset A ($ 200,000) Asset B ($ 180,000)

7. Contract Manufacturing, Inc. is considering

a. Rank these investments based on their NPVs

8. A certain firm has the following stream of cash flows:

Year Cash Flows

a. Fill in the following table:

Discount Rate NPV

c. Use the table in (a) to plot the NPV profile.

a. Should Old Line invest in this processor?

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