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    Chapter 6 Invetsment Exercises

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    Antonio Jose Duarte
    - The firm needs $5 million upfront for marketing and development costs. It will then generate $1 million in profits per year for 10 years but have ongoing support costs of $100,000 per year indefinitely. - At a 6% discount rate, the NPV is $693,420.38 so the firm should undertake the project. The NPV is also positive at a 2% discount rate but negative at 12%, so the decision depends on the discount rate used.

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    Chapter 6 Invetsment Exercises

    Uploaded by

    Antonio Jose Duarte
    45 views14 pages
    - The firm needs $5 million upfront for marketing and development costs. It will then generate $1 million in profits per year for 10 years but have ongoing support costs of $100,000 per year indefinitely. - At a 6% discount rate, the NPV is $693,420.38 so the firm should undertake the project. The NPV is also positive at a 2% discount rate but negative at 12%, so the decision depends on the discount rate used.

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    - The firm needs $5 million upfront for marketing and development costs. It will then generate $1 million in profits per year for 10 years but have ongoing support costs of $100,000 per year indefinitely. - At a 6% discount rate, the NPV is $693,420.38 so the firm should undertake the project. The NPV is also positive at a 2% discount rate but negative at 12%, so the decision depends on the discount rate used.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    45 views14 pages

    Chapter 6 Invetsment Exercises

    Uploaded by

    Antonio Jose Duarte
    - The firm needs $5 million upfront for marketing and development costs. It will then generate $1 million in profits per year for 10 years but have ongoing support costs of $100,000 per year indefinitely. - At a 6% discount rate, the NPV is $693,420.38 so the firm should undertake the project. The NPV is also positive at a 2% discount rate but negative at 12%, so the decision depends on the discount rate used.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    of 14

    Bill Clinton reportedly was paid $10 million to write his book My Way.

    The book took three


    years to write. In the time he spent writing, Clinton could have been paid to make speeches.
    Given his popularity, assume that he could earn $8 million per year (paid at the end of the year)
    speaking instead of writing. Assume his cost of capital is 10% per year.

    What is the NPV of agreeing to write the book (ignoring any royalty payments)?
    0 10,000,000 cost of capital 10%
    1 -8,000,000
    2 -8,000,000 NPV -9,894,815.93 € by simple formula
    3 -8,000,000 or
    NPV -9,894,815.93 € using PV of annuity formula

    Assume that, once the book is finished, it is expected to generate royalties of $5 million in the
    first year (paid at the end of the year) and these royalties are expected to decrease at a rate
    of 30% per year in perpetuity. What is the NPV of the book with the royalty payments?

    0 10,000,000 NPV
    1 -8,000,000 1) calculate the PV of growing perpetuity @T4
    2 -8,000,000
    3 -8,000,000 12,500,000.00 € g -0.3
    4 5,000,000 r 0.1
    5 3,500,000 =B21*(1-0.3) C 5,000,000
    6 ….
    2)Present value of C (Growing perpetuity)
    9,391,435.01 € because book will be finished @3 year and first payment

    NPV -503,380.92 €

    How many IRRs are there in part (a) of Problem 5? Does the IRR rule give the right answer in
    this case? How many IRRs are there in part (b) of Problem 5? Does the IRR rule work in this
    case?
    a) IRR 60.74%

    Rate NPV NPV


    0.1% -13,952,080 4,000,000
    5% -11,785,984 2,000,000
    10% -9,894,816
    0
    20% -6,851,852 0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0%
    -2,000,000
    30% -4,528,903
    40% -2,711,370 -4,000,000

    50% -1,259,259 -6,000,000


    61% 0 -8,000,000
    70% 897,619 -10,000,000
    80% 1,714,678 -12,000,000
    90% 2,407,056
    -14,000,000
    100% 3,000,000
    -16,000,000

    In this case (cost of capital is lower than IRR) we should accept the projet but consider that we have negative NPV we shou
    =B7+(B8/H7)*(1-(1/(1+H7)^3))

    d @3 year and first payment occurs @4

    100.0% 120.0%

    e have negative NPV we should refuse them


    FastTrack Bikes, Inc. is thinking of developing a new composite road bike. Development will
    take six years and the cost is $200,000 per year. Once in production, the bike is expected to make
    $300,000 per year for 10 years. Assume the cost of capital is 10%.

    Calculate the NPV of this investment opportunity, assuming all cash flows occur at the end
    of each year. Should the company make the investment?
    cost capital 10%
    T
    0 0
    1 -200
    2 -200
    3 -200
    4 -200
    5 -200
    6 -200
    7 300
    8 300
    9 300
    10 300
    11 300
    12 300
    13 300
    14 300
    15 300
    16 300
    OpenSeas, Inc. is evaluating the purchase of a new cruise ship. The ship would cost $500 million,
    and would operate for 20 years. OpenSeas expects annual cash flows from operating the ship to
    be $70 million (at the end of each year) and its cost of capital is 12%.

    NPV? we have to calculate the present value of annuity of revenues Cost


    NPV

    Present value of a annuity


    N 20 using formula 4.9 $522,861,053.70
    C $70,000,000.00
    R 12.0000%

    Prepare an NPV profile of the purchase.

    Rate NPV
    NPV
    0.1% $885,407,183.11 $1000000 000.00
    1% $763,188,707.64
    $800000 000.00
    5% $372,354,723.98
    10% $95,949,460.38 $600000 000.00
    12% $22,861,053.70
    15% -$61,846,796.84 $400000 000.00
    20% -$159,129,418.66
    $200000 000.00
    30% -$267,894,416.09
    $ 0.00
    0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 3
    -$200000 000.00

    -$400000 000.00

    IRR ? 12.72% or using formula -9.363%


    0 -500,000,000.00 €
    1 70000000
    2 70000000
    3 70000000
    4 70000000
    5 70000000
    6 70000000
    7 70000000
    8 70000000
    9 70000000
    10 70000000
    11 70000000
    12 70000000
    13 70000000
    14 70000000
    15 70000000
    16 70000000
    17 70000000
    18 70000000
    19 70000000
    20 70000000
    500,000,000.00 €
    $22,861,053.70

    NPV

    10.0% 15.0% 20.0% 25.0% 30.0% 35.0%


    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?
    cost capita 20%
    0 -100
    1 120 NPV 0.00 or 0
    IRR 20%
    You are indifferent to invest
    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?

    0 1,000.00 € cost of capital 25%


    40 100,000.00 €
    NPV -986.71 €
    IRR 12.20%
    when you have one single payment deferred on time use IRR = (FV/IV)^(1/N)
    e IRR = (FV/IV)^(1/N)
    Professor Wendy Smith has been offered the following deal: A law firm would like to retain her
    for an upfront payment of $50,000. In return, for the next year the firm would have access to 8
    hours of her time every month. Smith’s rate is $550 per hour and her opportunity cost of capital
    is 15% (EAR). What does the IRR rule advise regarding this opportunity? What about the NPV
    rule?
    cost of capital 15%
    0 50000 IRR 5.600%
    1 -52800 =(8*550)*-12 NPV 4086.957
    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

    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%.

    0 -5,000,000 cost of capital 6%


    1 1,000,000 -100000
    2 1,000,000 -100000 NPV = Initial Cost + PV annuilty 10 years - PV perpetuity
    3 1,000,000 -100000 cost of capital 6%
    4 1,000,000 -100000 Pvsupportcost -1,666,666.67 €
    5 1,000,000 -100000 initial cost -5,000,000.00 €
    6 1,000,000 -100000 Pvprofits 7,360,087.05 €
    7 1,000,000 -100000 NPV 693,420.38 €
    8 1,000,000 -100000
    9 1,000,000 -100000 cost of capital 2%
    10 1,000,000 -100000 Pvsupportcost -5,000,000.00 €
    …. -100000 initial cost -5,000,000.00 €
    Pvprofits 8,982,585.01 €
    NPV -1,017,414.99 €

    cost of capital 12%


    Pvsupportcost -833,333.33 €
    initial cost -5,000,000.00 €
    Pvprofits 5,650,223.03 €
    NPV -183,110.30 €

    How many IRRs does this investment opportunity have?


    ears - PV perpetuity

    Present value of a annuity

    N 10 using formula 4.9 $7,360,087.05


    C $1,000,000.00
    R 6.0000%
    You own a coal mining company and are considering opening a new mine. The mine itself will
    cost $120 million to open. If this money is spent immediately, the mine will generate $20 million
    for the next 10 years. After that, the coal will run out and the site must be cleaned and
    maintained at environmental standards. The cleaning and maintenance are expected to cost $2
    million per year in perpetuity. What does the IRR rule say about whether you should accept this
    opportunity? If the cost of capital is 8%, what does the NPV rule say?

    Timeline
    0 -120,000,000 cost of capital is 8% 8%
    1 20,000,000 Pvannuityrevenues 134,201,627.98 €
    2 20,000,000 Present value of a annuity
    3 20,000,000
    4 20,000,000 N 10
    5 20,000,000 C $20,000,000.00
    6 20,000,000 R 8.0000%
    7 20,000,000
    8 20,000,000
    9 20,000,000 PvperpetuitycleansT10 -25,000,000.00 €
    10 20,000,000
    11 -2,000,000.00 €

    NPV 2,621,790.78 €
    Solve for IRR ?

    Rate NPV
    0% -13952079.9
    5% -11785984.2
    10% -9894815.93
    20% -6851851.85
    30% -4528903.05
    40% -2711370.26
    50% -1259259.26
    61% 0
    70% 897618.563
    80% 1714677.641
    90% 2407056.422
    100% 3000000
    he mine itself will
    generate $20 million

    expected to cost $2
    u should accept this

    using formula 4.9 $134,201,627.98

    transform in Pvattimeo -11,579,837.20 €

    In the NPV calculation whenever a perpetuity starts at T+X we need to calculate


    the perpetuity at the time it starts and then go back to the present value at time
    zero.

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