Chapter 8: INVESTMENT APPRAISAL USING DCF METHODS

1. Investment is possible in one or more of three projects:

A B C
£ £ £
Outlay 10,000 7,000 1,250
Expected returns (t1-t4) 4,000 2,500 325
The firm can borrow the finance at 10% pa.
Which project(s) should be undertaken?
A A only
B A and B
C A and C
D A, B and C

2. An organisation with a cost of capital of 10% is considering investing in a

project costing £500,000 now that would yield cash inflows of £100,000 per
annum in perpetuity starting in a year’s time. What is the NPV of the project?
A £500,000
B £40,909
C £90,909
D £1,000,000

3. If your company is to receive a payment of £900 for a credit sale in 60 days it

would be worth how much to you today if your opportunity costs is 8% per
annum?

A £888.53
B £900.00
C £911.62
D £830.00

4. A firm is considering an investment which will generate a cash flow in exactly

five year’s time. The discount rate for the investment is 15% per annum. To
deduce the present value of the projected cash flow, we have to multiply the
amount of the cash flow to be received in five years’ time by?
A 1/(1.15)5
B (1.15)5
C 1/(0.15)5
D (0.15)5

5. An investment of £50,000 to be made on 31 December 20X8 will produce an

annual return of £7,000 in perpetuity, with the first income occurring on 1 January
20X9.
What (to the nearest £10) is the net present value of this investment on 31
December 20X7 discounted at 12%?
A £2,090
B £7,440
C £8,330
D £13,690

6. An investment of £100,000 now is expected to generate equal annual cash

flows to perpetuity of £15,000 pa, commencing in five years’ time.
If the discount rate is 10% pa, what is the net present value of the
investment (to the nearest £10)?
A -£15,330
B -£6,830
C +£2,450
D +£50,000

7. A two year project has the following annual cash flows.

£
Initial cost (400,000)
12 months later 300,000
24 months later 200,000
The cost of capital is estimated at 15% per annum during the first year and 17%
per annum during the second year.
What is the net present value of the project (to the nearest £500)?
A £2,500
B £7,000
C £9,500
D £12,000

8. A company is considering undertaking a cost reduction project which will

require an outlay of £450,000 in one year’s time. Savings in costs are likely to amount
to £200,000 for the first year, rising to £300,000 for the following year. The
company’s cost of capital is 10%.
 If all cash savings are deemed to arise at the end of each year, what is the
NPV of the project in today’s terms (to the nearest £100)?
A (£20,200)
B (£18,600)
C £18,600
D £20,200

9. A company has two mutually-exclusive projects available to it, details are as

follows:
Project Cash flows
t0 t1 t2 t3
£ £ £ £
X (£18,160) 10,000 10,000
10,000
Y (£18,160) - -
35,500
The company’s cost of capital is 15% pa.
Which project(s) should the company accept?
A Neither
B X only
C Y only
D Both
10. A firm is evaluating the following four mutually-exclusive projects. All four
projects involve the same initial outlay and have positive net present values. The
projects generate the following cash inflows during their lives:
t1 t2 t3 t4
£ £ £ £
Project A 500 400 600
300
Project B 300 600 500
400
Project C 500 300 600
400
Project D 300 500 600
400
Which project should be chosen?
A Project A
B Project B
C Project C
D Project D

11. A company has identified two mutually-exclusive projects:

Project I Project II
Discounted payback period 2.8 years 3.2 years
Net present value £17,200 £15,700
Internal rate of return 18% 22%
Average accounting rate of return 19% 21%
Cost of capital is 15%.
Assuming that the directors wish to maximise shareholder wealth and that no
shortage of capital is expected, which project should the company choose?
A Project I because it has the shorter payback period
B Project I because it has the higher net present value
C Project II because it has the higher internal rate of return
D Project II because it has the higher accounting rate of return

12. The management of XYZ Ltd is happy to make a choice from three projects.
The projects are not mutually-exclusive and capital is not in short supply.
Project I Project II Project
III
ARR 15% 12% 23%
Payback period 3 2 4
NPV £3,000 (£1,000) £5,000
IRR 20% 12% 15%
Which of the project(s) should be undertaken?
A I only
B I and II only
C I and III only
D I, II and III

13. The Glass Jar Company is considering expanding its product range by making
a new design of decorative bottle which will incur the following costs:
1. The costs of its recently commissioned market research study
2. Heat & Light to the currently unused factory building where the new line will
operate.
3. The salary and other costs of replacing the project engineer who will be
assigned to the project from other duties.
 4. Rent and rates allocation on the currently unused factory building on the main
factory site where the new line will operate.
Which of the above costs will be relevant in its DCF calculation?

A 1, 2, 3 and 4
B 2, 3 and 4
C 2 and 3
D 3 only

14. The NPV of the following set of cash flows is: Year 0 1 2
3
-£1,000 £500
£500 £500
Discount rate: 12%.
A +£201
B +£1,201
C +£889
D -£1,201
15. A contract is due to be commenced immediately. In one year’s time it will
require material XG. Price data relating to XG are as follows:
£
Cost now 7,800
Cost in one year’s time 8,800
The cost of storing XG for one year is £110, payable in one year’s time.
If the contractor’s cost of capital were 10% pa, what would be the present
value of the cost of using material XG, assuming the contractor wishes to
maximise net present value?
A £7,800
B £7,900
C £7,910
D £8,000

16. Suppose we have two mutually exclusive land development projects. The first
is an office building which can be constructed for an initial outlay of £20
million and sold a year later for £24 million. The other use of the land is for a
parking lot where an initial outlay of £10,000 will produce a cash inflow of
£10,000 per year forever.
The NPV of the building project is given by: NPVB = -£20,000,000 +
[£24,000,000 / (1+i)] where i is the cost of capital. The NPV of the perpetuity
producing parking project is given by the expression: NPVP = -£10,000 +
(£10,000 / i).
Calculate the NPVs of both projects at a 15% cost of capital.

A NPVB = £869,565.22 and NPVP = £56,666.67

B NPVB = £1,818,181.82 and NPVP = £90,000
C NPVB = £0 and NPVP = £40,000
D NPVB = -£800,000 and NPVP = £30,000

17. Which of the following changes will increase the NPV of a project?
A An increase in the initial cost of the project
B A decrease in the discount rate
C A decrease in the size of the cash inflows
D A decrease in the number of cash inflows
18. The decision rule for net present value is to:
A accept all projects with positive net present values.
B reject all projects lasting longer than 10 years.
C accept all projects with cash inflows exceeding initial cost.
D reject all projects with rates of return exceeding the opportunity cost of capital.
19. As the director of capital budgeting for Denver Corporation, you are evaluating
two mutually exclusive projects with the following net cash flows:
Project X Project Z
Year Cash Flow Cash Flow
0 -£100,000 -£100,000
1 50,000 10,000
2 40,000 30,000
3 30,000 40,000
4 10,000 60,000

If Denver’s cost of capital is 15 percent, which project would you choose?

A Project Z, since it has the higher NPV

B Project X, since it has the higher NPV
C Neither project
D Both projects
20. Hancock Furniture Inc. is considering new expansion plans for building a new
store. In reviewing the proposed new store, several members of the firm's
financial staff have made a number of points regarding the proposed project.
Which of the following items should the CFO include in the analysis when
estimating the project's net present value (NPV)?
A The new store is expected to take away sales from two of the firm's existing
stores located in the same town.
B The company owns the land that is being considered for use in the proposed
project.
This land could instead be leased to a local developer.
C The company spent $2 million two years ago to put together a national
advertising campaign. This campaign helped generate the demand for some of
its past products, which have helped make it possible for the firm to consider
opening a new store.
D Statements A and B are correct.

21. Ellison Products is considering a new project that develops a new laundry
detergent, WOW. The company has estimated that the project's NPV is £3
million, but this does not consider that the new laundry detergent will reduce
the revenues received on its existing laundry detergent products. Specifically,
the company estimates that if it develops WOW the company will lose
£500,000 in after-tax cash flows during each of the next 10 years because of
the cannibalization of its existing products. Ellison's WACC is 10 percent.
What is the net present value (NPV) of undertaking WOW after
considering externalities?
A £3,000,000.00
B -£72,283.55
C £2,807,228.00
D -£3,072,283.55