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Tutorial 07

Tutorial 07

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Tutorial 07

Tutorial 07

Uploaded by

1175469550
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© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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FNCE10002 Principles of Finance

Semester 2, 2024

Capital Budgeting I
Tutorial Questions for Topic 7’s Lecture

Priority Questions: A1, A2, B1, B4 and B5

Note that questions flagged as “EXM” are past exam questions that I’ve used in this subject or
subjects similar in scope to this subject, while those flagged as “TXT” are sourced from the textbook.
Note that any questions not covered in your tutorial should be viewed as study questions for the final
exam.

A. Problems and Case Study

A1.EXM You are deciding between two mutually exclusive investment opportunities. Both
require the same initial investment of $10 million. Project A will generate $2.0 million per
year (starting at the end of the first year) forever. Project B will generate $1.5 million at the
end of the first year and the cash flows will then grow at a rate of 2% per annum forever.

a) Which investment has the higher IRR?

b) Which investment has the higher NPV when the required rate of return is 7%?

c) For what values of the required rate of return does picking the higher IRR project give the
same decision as the NPV method? (Hint: Set the NPVs equal to each other and solve for
the required rate of return.)

d) Using your analysis in part (c) and the incremental IRR rule which investment would you
choose when the required rate of return is 7%? At what required rate of return would your
decision change and why?

A2.TXT The cash flows associated with three independent projects are as follows:

Net Cash Flows Project Alpha Project Beta Project Gamma


Year 0 –$1,500,000 –$400,000 –$7,500,000
Year 1 $300,000 $100,000 $2,000,000
Year 2 $500,000 $200,000 $3,000,000
Year 3 $500,000 $200,000 $2,000,000
Year 4 $400,000 $100,000 $1,500,000
Year 5 $300,000 –$200,000 $5,500,000

Tutorial Questions for Topic 7’s Lecture 1


a) Calculate the payback period of each investment.

b) Which investments does the company accept if the cut-off payback period is three years?
What if the cut-off is four years?

c) Which one of these projects is a project that almost certainly should be rejected, but
might be accepted if the company uses the payback period method? Explain.

d) Which one of these projects almost certainly should be accepted (unless the company’s
discount rate is very high), but might be rejected if the company uses the payback period
method. Explain.

e) What is the maximum number of internal rates of return that each project can have and
why?

A3. Refer to the case study related to the market’s interpretation of NPV covered in class where
we examined Microsoft’s takeover of LinkedIn in 2016 (pages 7.12 – 7.15 of your lecture
notes). Suppose Microsoft announces that because of its inability to fully integrate LinkedIn
into its Office software/cloudware it has decided to sell its LinkedIn operations at a
significantly lower value compared to the US$26 billion it had paid in 2016. How do you
think the market would react to this decision and why? Explain.

B. Multiple Choice Questions

For each question pick the most reasonable response based only on the information provided.

B1.EXM You have analyzed an investment project which has a conventional cash flow pattern.
Assuming that the original project has a positive NPV, if the initial outlay and all the expected
net cash flows are doubled what is the most likely effect on the project’s net present value and
internal rate of return?

a) Both the IRR and NPV would increase.


b) The IRR would stay the same and the NPV would increase.
c) The IRR would increase and the NPV would stay the same.
d) Both the IRR and NPV would stay the same.

B2.EXM Which of the following items of information is least likely to be necessary for
evaluating an investment project?

a) The project’s initial cash outlay.


b) The project’s life.
c) The project’s internal rate of return.
d) The project’s required rate of return (or discount rate).

B3.EXM Which of the following statements about the payback period method of project
evaluation are most likely to be true?

I. It is very rarely used by managers in the “real” world.


II. It tends to discriminate against projects with long development periods.
III. It tends to discriminate against projects with large net cash flows later in their lives.

a) I and II only.
b) II and III only.
c) I and III only.

Tutorial Questions for Topic 7’s Lecture 2


d) I, II and III.
Questions B4 and B5 are based on the following information.

A project has an initial outlay of $50,000 and its expected net cash flows are $12,000 per year for the
next eight years. The project is to be evaluated using a required rate of return of 12% p.a.

B4. The project’s net present value is closest to:

a) –$40,433.
b) –$9,612.
c) $9,612.
d) $40,433.

B5. The project’s internal rate of return is closest to:

a) 9.5%.
b) 11.3%.
c) 14.6%.
d) 17.3%.

C. Closing the loop with Desmos interactive graphs

This week we are going to demonstrate graphically how IRR and NPV may give conflicting answers
using Question A1 as our example.

Open the Desmos graph that sets out the relationship between NPV and IRR for Projects A and B
from question A1: https://www.desmos.com/calculator/37gjvykkpo

Answer the questions asked in A1, but this time do so only by changing the discount rate using the
slider that allows you to specify the discount rate r.

Tutorial Questions for Topic 7’s Lecture 3

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