Exercises

Chapter 2
Investment Decision

Corporate Finance (BIB) - 2021

Florian Kiesel

Jan Schnitzler

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 Part 2: Investment Decision

Exercise 2.1

Comparing Investment Criteria. Define each of the following investment rules and discuss
any potential shortcomings of each. In your definition, state the criterion for accepting or
rejecting independent projects under each rule.

1. Payback period
2. Internal rate of return
3. Profitability Index
4. Net present value

Exercise 2.2

Your brother wants to borrow $10,000 from you. He has offered to pay you back $12,000
in a year. If the cost of capital of this investment opportunity is 10%, what is its NPV?
Should you undertake the investment opportunity? Calculate the IRR and use it to
determine the maximum deviation allowable in the cost of capital estimate to leave the
decision unchanged.

Exercise 2.3

You are considering investing in a start-up company. The founder asked you for $200,000
today and you expect to get $1,000,000 in nine years. Given the riskiness of the investment
opportunity, your cost of capital is 20%. What is the NPV of the investment opportunity?
Should you undertake the investment opportunity? Calculate the IRR and use it to
determine the maximum deviation allowable in the cost of capital estimate to leave the
decision unchanged.

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 Exercise 2.4

Grenoble Industries has a project with the following projected cash flows:

Initial Cost, Year 0: $240,000

Cash flow year one: $25,000

Cash flow year two: $75,000

Cash flow year three: $150,000

Cash flow year four: $150,000

a. Using a 10% discount rate for this project and the NPV model should this

project be accepted or rejected?

b. Using a 15% discount rate?

c. Using a 20% discount rate?

Exercise 2.5

Grenoble Industries has four potential projects all with an initial cost of $2,000,000. The
capital budget for the year will only allow Swanson industries to accept one of the four
projects. Given the discount rates and the future cash flows of each project, which project
should they accept?

Cash Flows Project M Project N Project O Project P

Year one $500,000 $600,000 $1,000,000 $300,000

Year two $500,000 $600,000 $800,000 $500,000

Year three $500,000 $600,000 $600,000 $700,000

Year four $500,000 $600,000 $400,000 $900,000

Year five $500,000 $600,000 $200,000 $1,100,000

Discount Rate 6% 9% 15% 22%

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 Exercise 2.6

Your firm is considering the launch of a new product, the XJ5. The upfront development
cost is $10 million, and you expect to earn a cash flow of $3 million per year for the next
five years. Plot the NPV profile for this project for discount rates ranging from 0% to 30%.
For what range of discount rates is the project attractive?

Exercise 2.7

You are considering an investment in a clothes distributor. The company needs $100,000
today and expects to repay you $120,000 in a year from now. What is the IRR of this
investment opportunity? Given the riskiness of the investment opportunity, your cost of
capital is 20%. What does the IRR rule say about whether you should invest?

Exercise 2.8

You have been offered a very long term investment opportunity to increase your money
one hundredfold. You can invest $1000 today and expect to receive $100,000 in 40 years.
Your cost of capital for this (very risky) opportunity is 25%. What does the IRR rule say
about whether the investment should be undertaken? What about the NPV rule? Do they
agree?

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 Exercise 2.9

Innovation Company is thinking about marketing a new software product. Upfront costs
to market and develop the product are $5 million. The product is expected to generate
profits of $1 million per year for 10 years. The company will have to provide product
support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses
occur at the end of the year.

a. What is the NPV of this investment if the cost of capital is 6%? Should the firm
undertake the project? Repeat the analysis for discount rates of 2% and 12%.
b. How many IRRs does this investment opportunity have?
c. Can the IRR rule be used to evaluate this investment? Explain.

Exercise 2.10

You are a real estate agent thinking of placing a sign advertising your services at a local
bus stop. The sign will cost $5000 and will be posted for one year. You expect that it will
generate additional revenue of $500 per month. What is the payback period?

Exercise 2.11

You own a car dealership and are trying to decide how to configure the showroom floor.
The floor has 2000 square feet of usable space. You have hired an analyst and asked her
to estimate the NPV of putting a particular model on the floor and how much space each
model requires:

In addition, the showroom also requires office space. The analyst has estimated that office
space generates an NPV of $14 per square foot. What models should be displayed on the
floor and how many square feet should be devoted to office space?

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 Exercise 2.12

Kaimalino Properties (KP) is evaluating six real estate investments. Management plans to
buy the properties today and sell them five years from today. The following table
summarizes the initial cost and the expected sale price for each property, as well as the
appropriate discount rate based on the risk of each venture.

KP has a total capital budget of $18,000,000 to invest in properties.

a. What is the IRR of each investment?

b. What is the NPV of each investment?
c. Given its budget of $18,000,000, which properties should KP choose?
d. Explain why the profitability index method could not be used if KP’s budget were
$12,000,000 instead. Which properties should KP choose in this case?

Exercise 2.13

Orchid Biotech Company is evaluating several development projects for experimental

drugs. Although the cash flows are difficult to forecast, the company has come up with the
following estimates of the initial capital requirements and NPVs for the projects. Given a
wide variety of staffing needs, the company has also estimated the number of research
scientists required for each development project (all cost values are given in millions of
dollars).

a. Suppose that Orchid has a total capital budget of $60 million. How should it
prioritize these projects?
b. Suppose in addition that Orchid currently has only 12 research scientists and does
not anticipate being able to hire any more in the near future. How should Orchid
prioritize these projects?
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 c. If instead, Orchid had 15 research scientists available, explain why the profitability
index ranking cannot be used to prioritize projects. Which projects should it choose
now?

Exercise 2.14

(a) What is meant by the term “mutually exclusive projects” ?

(b) Explain why the IRR decision rule could give the wrong result when comparing mutually
exclusive projects.

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