MA 155 PROBLEM SET: Capital Budgeting Exercise 1.

Projects [3] Consider the following projects: Cash ows, thousands of dollars A B C C0 1 2 3 C1 1 1 1 C2 C3 0 0 1 4 1 0 C4 0 1 1 C5 0 1 1

1. If the opportunity cost of capital is 10 percent, which projects have a positive NPV? 2. Calculate the payback period for each project. 3. Which project(s) would a rm using the payback rule accept if the cuto period were 3 years? Exercise 2. Mutually Exclusive Projects (BM 5.7) [4] Consider the following two mutually exclusive projects A and B: Period A B 0 1 2 3 100 60 60 0 100 0 0 140

1. Calculate the NPV of each project for discount rates of 0, 10 and 20%. Plot these on a graph with NPV on the vertical axis and discount rate on the horizontal. 2. What is the approximate IRR of each project? 3. In what circumstances should the company accept project A? 4. Calculate the NPV of the incremental investment (B-A) for discount rates of 0, 10 and 20%. Plot these on your graph. Show that the cases in which you would accept A are also those in which the IRR on the incremental investment is less than the opportunity cost of capital. Exercise 3. MacGregor Whiskey Co (BM 9.11) [4] The MacGregor Whiskey Company is proposing to market diet scotch. The product will rst be testmarketed for 2 years in Southern California at an initial cost of $500,000. This test launch is not expected to produce any prots but should reveal consumer preferences. There is a 60 percent chance that demand will be satisfactory. In this case, McGregor will spend $5 million to launch the scotch nationwide and will receive an expected annual prot of $700,000 in perpetuity. If demand is not satisfactory, diet scotch will be withdrawn. Once consumer preferences are known, the product will be subject to an average degree of risk, and therefore, McGregor requires a return of 12 percent on its investment. However, the initial test-market phase is viewed as much riskier, and McGregor demands a return of 40 percent on this initial expenditure. 1. What is the NPV of the diet scotch project? Exercise 4. Halcyon Lines (BM 3.5) [3] Halcyon Lines is considering the purchase of a new bulk carrier for $8 million. The forecast revenues are $5 million a year and operating costs are $4 million. A major ret costing $2 million will be required after both the fth and tenth years. After 15 years, the ship is expected to be sold for scrap at $1.5 million. 1

1. If the discount rate is 8 percent, what is the ships NPV? Exercise 5. Projects [2] You are given the following information about three projects. Each project last for one period only. Project A B C 1. Find the cash ow in period 1 (C1 ). 2. Suppose the opportunity cost of capital is 10%. Calculate the net present value (NPV) of each of the three projects. 3. Which projects would you accept? Exercise 6. A project has costs of 1 million at startup. The project has a positive cash ow of 1 million for the next three years and a cleanup cost of 2 million in the fourth year. Disregard taxes. What are the internal rate(s) of return for the project? (a) -12.45%. (b) 0.00% and 52.15%. (c) 2.00%. (d) 13.38% and 52.15%. (e) I choose not to answer. Exercise 7. A rm will have a stall at a summer amusement theme park. It will invest $1,000 and considers three mutually exclusive projects; A, B and C. The cash ows of these projects are given in the table below. The cost of capital is 10%. Year 1 2 2200 -1210 4400 -2420 7700 -2420 Investment Outlay (C0 ) 1 1 2 Rate of return (IRR) 8% 20% 4%

Project A B C

0 -100 -500 -500

What is the relative ranking of the three projects to the rm? 1. It prefers A to C, and prefers C to B. 2. It is indierent between B and C, and prefers both to A. 3. It is indierent between A and C, and prefers both to B. 4. It prefers C to B, and prefers B to A. 5. I choose not to answer. 2

Exercise 8. A company is evaluating a project, developing a new computer design. The project requires an investment of 2 million. The revenues in later years depend on the price the computer achieves in the market. The company calculates expected cash ows for the next 5 years as 550,000 per year. However, this assumes that the company sells computers in all the next ve years. The company has the option of closing down production early if the computer price develops unfavourably. The project is to be evaluated at a required rate of return of 10%. Which of the following statements is correct? 1. The NPV of the project is above 84,933. 2. The NPV of the project equals 84,933. 3. The NPV of the project is below 84,933. 4. There is not enough information to state whether the NPV of the project is above, equal to, or below 84,933. 5. I choose not to answer. Exercise 9. A company named Magne Jernilden ASA is evaluating a move to a new location. The local community is oering a sweetener to encourage the move. The local community is oering Magne Jernilden ASA a 5 year, zero coupon, interest free loan of kr 5 million. Magne Jernilden ASA is paying 10% interest on its current debt. What is the value to Magne Jernilden ASA of the oer made by the local community? 1. kr 0 2. kr 0,2 million 3. kr 0,5 million 4. kr 1,9 million 5. I choose not to answer.

Empirical Solutions MA 155 PROBLEM SET: Capital Budgeting Exercise 1. Projects [3] Project A B C NPV -91 4044 39 Payback 1 2 4

c) Using payback, I will accept A and B. However, I should accept B and C, since those are the positive-NPV projects. Exercise 2. Mutually Exclusive Projects (BM 5.7) [4] C0 -100 -100 C1 60 0 C2 60 0 C3 0 140

A B NPV: A B 0% 20 40

10% 4.13 5.18

20% -8.33 -18.98

IRR 13.066 11.869

NPV 6

c) When A has a higher (positive) NPV than B. This can easiest be seen in the gure above. An alternative way is to nd when the IRR on the dierence investment is higher than the opportunity cost of capital (In this case, it is when 10.278 r 13.066). d) Incremental investment. Cash ows: C0 0 C1 -60 C2 -60 C3 140

BA

NPV: BA 0% 20 10% 1.051 20% -10.641 IRR 10.278

Exercise 3. MacGregor Whiskey Co (BM 9.11) [4] N P V2 if unsuccessful = 0 700 N P V2 if successful = 5000 + = 833 .12 (.4 0) + (.6 833) = $245, 000 N P V0 = 500 + 1.42 Exercise 4. Halcyon Lines (BM 3.5) [3] 1. First, look at the table of cash ows: (all numbers in millions) Year Income Ret Scrap 1 1 2 1 4 1 5 1 -2 10 1 -2 14 1 15 1 1.5

PV = 1 +

1 1 1 r (1 + r)15 r

(2) 1.5 (2) + + (1 + r)5 (1 + r)10 (1 + r)15 = 6.743

= 1 8.559 2 0.681 2 0.463 + 1.5 0.315

N P V = P V C0 = 6.743 8.000 = 1.256 Since the NPV is negative, dont invest. Exercise 5. Projects [2] 1. 0= C1 C0 C1 = C0 (1 + r) 1+r A B C 2. NPV = A B C 1.08 1.20 2.08 C1 C0 1+r 0.018 0.090 0.109

3. Accept B only, it has positive NPV, which could also be seen from the fact that it was the only project with an IRR higher than the opportunity cost of capital. 5

Exercise 6. The cashows sum to zero, one IRR is zero. 52.15% is also correct. (b) is correct. Exercise 7. Exercise 8. Calculate the NPV assuming the company maintains production for ve years

NPV

= 2 0.55 (1 + 0.1)1 0.55 + (1 + 0.1)2 0.55 + (1 + 0.1)3 0.55 + (1 + 0.1)4 0.55 + (1 + 0.1)5 = 0.0849327, +

or 84.933. The option to abandon early can only add (a) is correct Exercise 9. Beregn nverdien av tilbudet. t 0 5 NPV = 5 + (d) is correct.

to this NPV. Hence

Ct 5 5

5 = 1.89539 (1 + 0.1)5