FINM 2412 Financial Management for Business

Tutorial 6 Questions

Question 1
You are given the following information relating to a proposed capital investment:

Year 0 1 2 3 4

Net cash flow (after-tax) (7,000) 2,500 3,200 3,000 2,500

You are required to calculate the project’s:

(a) NPV

(b) IRR (Hint: try 21% and 22%)

(c) Payback period.

Under each method, explain whether or not the firm should accept the project. For
investments of this type, the firm’s risk-adjusted discount rate is 15% p.a. The cut-off for
payback period is 2 years.

Question 2
Assume that a firm with a cost of capital of 10% p.a. must choose between two mutually
exclusive projects having net (after-tax) cash flows as shown below:

Project Initial Outlay Year

1 2 3

X -$10,000 $7,000 $4,000 $2,000

Y -$10,000 $2,000 $4,000 $8,200

(a) Using the NPV method, which project is preferred?

(b) Using the IRR method, which project is preferred? (Hint: for project X, try 18.2% and
21.1%; for project Y, try 13.3% and 15.8%)

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Question 3
Use the data on Projects X and Y from Question 2 (above).

Management seeks to measure the sensitivity of the net present value to variations in the
cost of capital. To provide such analysis, prepare a single graph showing NPV profiles of
both Projects X and Y. Completing the table below may help.

NPV at various discount rates

0% 5% 10% 15% 20% 25%

(a) Where do the two NPV profiles cut the x-axis? What do these figures represent?
(b) At what point (roughly) do the NPV profiles intersect? How can we interpret this
point?
(c) From the graph, which project is preferred at the firm’s 10% risk-adjusted discount
rate? What if it was 15%? What if it was 20%?

Question 4
Kalorie Cola is considering buying a special-purpose bottling machine for $28,000. It is
expected to have a useful life of 7 years with a zero disposal price. The plant manager
estimates the following savings in cash-operating costs:

YEAR AMOUNT

1 $10,000

2 8,000

3 6,000

4 5,000

5 4,000

6 3,000

7 3,000

Total $39,000

The Plant Manager argues that, since the total cash savings ($39,000) exceed the outlay
($28,000), Kalorie Cola should definitely purchase the machine.

(a) Calculate whether the bottling machine should be purchased according to the
following methods: (i) net present value (NPV), and (ii) internal rate of return (IRR)
(Hint: try 11%, 12% and 13%). Kalorie Cola’s required rate of return is 16% p.a.

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 (b) Explain to the Plant Manager why his logic for purchasing the machine is flawed.
Why can't we compare the total cash savings with the machine cost?

Question 5
UQ Business School Pty Ltd designs a range of eye-catching fluorescent t-shirts. The
designers have always hand-drawn and painted their new fashion ranges. The new head
of the Business School is considering purchasing a new computer-aided design (CAD)
package to allow her designers to create their designs on computers. The CAD project is
expected to generate cost savings by improving productivity. Also, UQBS can submit
electronic templates of its latest designs to the manufacturers of its fashion ranges, which
would also make significant savings. The upfront hardware and software costs to UQBS is
estimated at $300,000. The computers and software have a 5-year useful life. After that,
the technology will be obsolete and will have no salvage value. The CAD project is
expected to save UQBS approximately $88,000 (after tax) per annum.

Advise the new head on the acceptability of the CAD proposal, applying the following
capital budgeting methods:

(a) Net Present Value

(b) Internal Rate of Return (Hint: try 13%, 14% and 15%)

Assume that all cash flows occur at the end of each period, with the exception of the
upfront outlay, which is paid at the commencement of the project. Assume that UQBS’s
required rate of return on this project is 10%.