BFN3104

Chapter 10
Questions
1.

Define capital rationing.

Capital rationing is putting one or more types of limits on capital expenditures.

2.

Why might it be important to review and assess (post audit) a firms decisions?
What are some of the pitfalls associated with such a task?
Post audits are important because actual cash flows can be compared to the estimates.
This comparison can help improve the ability of the analysts that made the estimates.
One of the pitfalls of post audits is the difficulty of measuring opportunity costs and
options. Also, measuring and identifying cash flows from a decision may be
impossible.

3.

Cite and briefly discuss six factors that can be especially difficult to quantify for
inclusion in a capital budgeting NPV calculation.
There are many factors that are difficult to quantify in a capital budgeting NPV
calculation. One factor is the value of options that are part of a project. Another factor
that is difficult to quantify is any enhancement or erosion of existing projects due to
the selection of a new project. The likelihood of technological advances, which can
make the opportunity to postpone investment valuable, is also difficult to estimate.
Costs and benefits connected with relationship with suppliers are not simple to
quantify and can have an effect on the success of a project. Another cost that is
difficult to measure is the search cost of finding high quality employees with the
expertise needed for the project. Finally, the experience a firm has in dealing with
machinery and other inputs required for the project is difficult to measure but can
have a direct impact on a projects NPV.

4.

Cite and briefly discuss potential pitfalls encountered in estimating the value of
future investment options, in the context of our warning about real options.
A potential pitfall in estimating the value of future investment opportunities is that
manager who wants to undertake the project may overestimate the value of future
opportunities or double-count certain aspects of various options, thus incorrectly
estimating a positive NPV for a negative NPV project.

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Problems
5. A potential investments NPV is RM2 million. For an additional outlay of RM0.1
million, you will have the option to add businesses in the region. If circumstances are
favourable (probability=0.5), the expansion option has an NPV of RM5 million. If
circumstances are unfavourable (probability=0.5), the expansion option has an NPV
of 0. What is the total NPV of the investment, including the cost and expected value
of the expansion option?
Value option = (0.50 * RM5,000,000) + (0.50 * RM0) = RM2,500,000
Total NPV = DCF NPV + Value options Cost of options
Total NPV = RM2,000,000 + RM2,500,000 RM100,000 = RM400,000
6. You have a restaurant that Exxon Mobil would like to convert to a gas station. They
have made you a offer that nets you RM800,000 after taxes. Your required return is
12 percent.
a. You expect a RM125,000 cash flow after tax for the next 10 years. Should you
abandon?
Using Financial Calculator
n = 10, r = 12%, PMT = 125,000, FV = 0, PV = ?
PV = RM706,277.88
Sell because the abandonment value of RM800,000 is worth more than the cash
flows.
b. Assume your annual cash flow is RM175,000. What is the minimum offer you
would accept?
n = 10, r = 12%, PMT = 175,000, FV = 0, PV = ?
PV = RM988,789.03
RM988,789.03 is the minimum offer that would be accepted.
7. Suppose Intel can introduce a new technology now or wait one year. The cash flows
for investing now or postpone one year later are:
Time
Invest now
Invest one year

-50

10
-55

20
24

20
24

20
24

20
24

20
24

If the cost of capital is 10%, should Intel invest now or postpone and invest in one
year?
Invest now
NPV = 50 + 10/1.1 + 20/1.12 + 20/1.13 + 20/1.14 + 20/1.15 + 20/1.16 = RM28.01

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Invest in one year

NPV = 55/1.1 + 24/1.12 + 24/1.13 + 24/1.14 + 24/1.15 + 24/1.16 = RM32.71
Conclusion: The developer should postpone.
8. Consider the projects shown below (amounts in RM1,000).
Project

Initial cost
NPV

10
1.1

20
3.6

20
0.8

15
1.6

30
4.0

40
3.0

20
1.4

a. Compute the profitability index (PI) for each project.

Ranking
PIA = 1 + 1.1/10 = 1.11
3
PIB = 1 + 3.6/20 = 1.18
1
PIC = 1 + 0.8/20 = 1.04
6
PID = 1 + 1.6/15 = 1.11
3
PIE = 1 + 4.0/30 = 1.13
2
PIF = 1 + 3.0/40 = 1.08
4
PIG = 1 + 1.4/20 = 1.07
5
b. If you were rationed to RM115,000 for the initial investment, which projects
should you choose?
Project B, E, A, D and F should be chosen for a total outlay of RM115,000 and a
total NPV of RM 13,300.
c. If you were rationed to RM95,000 for the initial investment, which projects
should you choose?
Project B, E, A, D and G should be chosen for a total outlay of RM95,000 and a
total NPV of RM11,700.

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