Professional Documents
Culture Documents
Answers to the
assignments
Note! 10, 20,21 and 23 are not in the
assignment
9. a. The payback period is the time that it takes for the cumulative
undiscounted cash inflows to equal the initial investment.
Project A:
Cumulative cash flows Year 1 = 4,000
= 4,000
Cumulative cash flows Year 2 = 4,000 +5,500
= 9,500
Cumulative cash flows Year 3 = 4,000 + 5,500 + 8,000
= 17,500
> 14,000
The payback period is more than the 2 year cut-off and so project A would
be rejected.
Project B:
Cumulative cash flows Year 1 = 4,500
= 4,500
Cumulative cash flows Year 2 = 4,500 + 2,200
= 6,700
> 6,000
The payback period is less than the 2 year cut-off and so project B would
be accepted.
Companies can calculate a more precise value using fractional years. To
calculate the fractional payback period, find the fraction of year 2s cash
flows that is needed for the company to have cumulative undiscounted
cash flows of 6,000. Divide the difference between the initial investment
and the cumulative undiscounted cash flows as of year 2 by the
undiscounted cash flow of year 2.
Payback period = 1 + (6,000 4,500) / 2,200
Payback period = 1.68 years
b. Discount each projects cash flows at 12 percent. Choose the project
with the highest NPV.
Project A:
NPV = 14,000 + 4,000 / 1.12 + 5,500 / 1.122 + 8,000 / 1.123
NPV = -349.76
Project B:
NPV = 6,000 + 4,500 / 1.12 + 2,200 / 1.122 + 200 / 1.123
NPV = -85.96
The firm should choose neither project since both have negative NPVs.
10.(Note! This was not among the assignments, but it is good knowledge
to have./Max)Since payback period does not take into account time
value of money and the sum of the cash flows exactly equals the initial
investment, the NPV can only be zero with a zero discount rate. It can
never be positive. A zero discount rate is exceptionally unlikely to
occur in real life and so the NPV of the project must be negative.
11. Payback Period
Cumulative cash flows Year 1 = 35,000
= 35,000
Cumulative cash flows Year 2 = 35,000 + 10,000 = 45,000
The fractional part of year 2 is 10,000/15,000 = 0.67. The payback
period is 1.67 years.
The minimum discount rate to have an acceptable NPV is the internal rate
of return of the project. This is calculated by trial and error:
NPV = 0 = 45,000 + 35,000 / (1 + IRR) + 15,000 / (1+IRR) 2 + 5,000 /
(1+IRR)3
IRR = 15.12%
12. When we use discounted payback, we need to find the value of all cash
flows today. The value today of the project cash flows for the first four
years is:
Value today of Year 1 cash flow = 20,000/1.14 = 17,543.86
Value today of Year 2 cash flow = 35,400/1.142 = 27,239.15
Value today of Year 3 cash flow = 48,000/1.143 = 32,398.63
Value today of Year 4 cash flow = 54,500/1.144 = 32,268.38
To find the discounted payback, we use these values to find the payback
period. The 3 year cumulative discounted cash flow is 17,543.86 +
27,239.15 + 32,398.63 = 77,181.64. The fractional part of the third
year to make the discounted cash flows equal the initial investment is
(100,000 - 77,181.64)/32,268.38 = .21. So discounted payback period
is 3.21 years.
Since discounted cash flows sum to 109,450.02 there is no payback
period when the initial cost is 120,000 or 170,000.
19. a. The IRR is the interest rate that makes the NPV of the project equal
to zero. So, the equation that defines the IRR for this project is:
0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3 + C4 / (1 + IRR)4
0 = 5,000 2,500 / (1 + IRR) 2,000 / (1 + IRR)2 1,000 / (1 + IRR)3
1,000 / (1 +IRR)4
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
IRR = 13.99%
b. This problem differs from previous ones because the initial cash flow is
positive and all future cash flows are negative. In other words, this is a
NPV 0 600,000
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
IRR = 24.30%
Submarine Ride IRR:
NPV 0 1,800,000
(1 IRR)
(1 IRR) 2 (1 IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
IRR = 21.46%
Based on the IRR rule, the deepwater fishing project should be chosen
because it has the higher IRR.
b. To calculate the incremental IRR, we subtract the smaller projects cash
flows from the larger projects cash flows. In this case, we subtract the
deepwater fishing cash flows from the submarine ride cash flows. The
incremental IRR is the IRR of these incremental cash flows. So, the
incremental cash flows of the submarine ride are:
0
1
2
3
Deepwater CF
-600,000
270,000 350,000 300,000
1,000,00
Submarine CF
-1,800,000
0 700,000 900,000
Incremental CF
-1,200,000
730,000 350,000 600,000
Setting the present value of these incremental cash flows equal to zero, we
find the incremental IRR is:
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
Incremental IRR = 19.92%
For investing-type projects, accept the larger project when the incremental
IRR is greater than the discount rate. Since the incremental IRR, 19.92%, is
greater than the required rate of return of 15 percent, choose the
submarine ride project. Note that this is the choice when evaluating only
the IRR of each project. The IRR decision rule is flawed because there is a
scale problem. That is, the submarine ride has a greater initial investment
than does the deepwater fishing project. This problem is corrected by
calculating the IRR of the incremental cash flows, or by evaluating the NPV
of each project.
c. The NPV is the sum of the present value of the cash flows from the
project, so the NPV of each project will be:
Deepwater fishing:
96, 687.76
(1 0.15) (1 0.15) 2 (1 0.15)3
190, 630.39
(1 0.15)
(1 0.15) 2 (1 0.15)3
Since the NPV of the submarine ride project is greater than the NPV of the
deepwater fishing project, choose the submarine ride project. The
incremental IRR rule is always consistent with the NPV rule.
21. a. The cumulative cash flows for the project are presented below:
3
4
5
Cash Flow
-15,000
4,000 5,000 2,000 7,000 7,000
Cumulative
CF
-15,000 11,000 6,000 8,000 1,000 6,000
The payback period is equal to 4 + (1,000/6,000) = 4.1667 years
b. The NPV is equal to:
4, 000
5, 000
2, 000
7, 000
7, 000
393.51
2
3
4
(1 0.10) (1 0.10) (1 0.10) (1 0.10) (1 0.10)5
c. Since there are three changes of sign in the cash flows, there will be
three IRRs. Using trial and error or solver, the only one that makes sense
is:
IRR = 10.92%
d.
The Profitability Index (PI) is equal to:
PI = PV of cash flows subsequent to initial investment Initial investment
= 15,393.51 / 15,000
=1.026
22.
a. The payback period is the time that it takes for the cumulative
undiscounted cash inflows to equal the initial investment.
Trading Card game:
Payback period = 200 / 300 = .667 year
Board Game:
Payback period = 2,000/2,200 = 0.909 year
Since the Trading Card game has a shorter payback period than the Board
Game project, the company should choose the Trading Card game.
b. The NPV is the sum of the present value of the cash flows from the
project, so the NPV of each project will be:
Trading Card game:
NPV 200
300
100
100
230.50
2
(1 0.10) (1 0.10) (1 0.10)3
Board Game:
NPV 2, 000
2, 200
900
500
1,119.46
2
(1 0.10) (1 0.10) (1 0.10)3
Since the NPV of the Board Game is greater than the NPV of the Trading
Card game, choose the Board Game.
c. The IRR is the interest rate that makes the NPV of a project equal to
zero. So, the IRR of each project is:
Trading Card game:
NPV 0 200
300
100
100
2
(1 IRR ) (1 IRR ) (1 IRR )3
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
IRR = 90.13%
Board Game:
NPV 0 2, 000
2, 200
900
500
2
(1 IRR ) (1 IRR ) (1 IRR )3
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
IRR = 50.83%
Since the IRR of the Trading Card game is greater than the IRR of the Board
Game, IRR implies we choose the trading Card game.
d. To calculate the incremental IRR, we subtract the smaller projects cash
flows from the larger projects cash flows. In this case, we subtract the
Trading Card Game cash flows from the Board Game cash flows. The
incremental IRR is the IRR of these incremental cash flows. So, the
incremental cash flows are:
Trading Card
CF
Board CF
Incremental CF
-200
-2,000
-1,800
300
2,200
1,900
100
900
800
100
500
400
Setting the present value of these incremental cash flows equal to zero, we
find the incremental IRR is:
NPV 0 1,800
1,900
800
400
2
(1 IRR ) (1 IRR ) (1 IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
Incremental IRR = 46.31%
For investing-type projects, accept the larger project when the incremental
IRR is greater than the discount rate. Since the incremental IRR, 46.31%, is
greater than the required rate of return of 10 per cent, choose the Board
Game project. Note that this is the choice when evaluating only the IRR of
each project. The IRR decision rule is flawed because there is a scale
problem. That is, the Board Game has a greater initial investment than
does the Trading Card game. This problem is corrected by calculating the
IRR of the incremental cash flows, or by evaluating the NPV of each
project.
23. The cash flows from the investment are as follows
Cash
Flow
0
220,00
0
80,00
0
84,00
0
88,20
0
92,61
0
97,24
0.5
80, 000
84, 000
88, 200
92, 610 97, 240.5
112, 047
2
3
(1 0.10) (1 0.10) (1 0.10) (1 0.10) 4 (1 0.10)5
2
3
(1 IRR) (1 IRR) (1 IRR) (1 IRR) 4 (1 IRR) 5
80, 000 84, 000 88, 200 92, 610 97, 240.5
/ 220, 000
2
3
4
(1 .10) 5
(1 .10) (1 .10) (1 .10) (1 .10)
PI
PI 1.509
As NPV is positive, IRR is greater than the discounting rate and PI is greater
than one, the revision should be undertaken.
24. a. The payback period is the time that it takes for the cumulative
undiscounted cash inflows to equal the initial investment.
People Carrier:
Payback period = 200000 / 300000 = .667 year
SUV:
218, 754.56
(1 0.12) (1 0.12) 2 (1 0.12)3
SUV:
145,100.67
(1 0.12) (1 0.12) 2 (1 0.12)3
Since the NPV of the People Carrier is greater than the NPV of the SUV,
choose the People Carrier.
c. The IRR is the interest rate that makes the NPV of a project equal to
zero. So, the IRR of each project is:
People Carrier:
NPV 0 200,000
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
IRR = 90.13%
SUV:
NPV 0 500,000
Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:
IRR = 28.89%
Since the IRR of the People Carrier is greater than the IRR of the SUV, IRR
implies we choose the People Carrier.
d. You do not need to calculate the incremental IRR since in this case
because, even though the initial investment of the People Carrier is less, its
NPV is greater than the SUV.
ww
0%
E(Rp)
0%
Bp
0
25%
25%
0.3
50%
50%
0.6
75%
75%
0.9
100%
100%
1.2
125%
125%
1.5
150%
150%
1.8
18. There are two ways to correctly answer this question. We will work
through both. First, we can use the CAPM. Substituting in the value we are
given for each stock, we find:
E(RY) = .055 + .075(1.50) = .1675 or 16.75%
It is given in the problem that the expected return of Y is 17 percent, but
according to the CAPM, the return of the equity based on its level of risk
should be 16.75 percent. This means the equity return is too high, given its
level of risk. Equity Y plots above the SML and is undervalued. In other
words, its price must increase to reduce the expected return to 16.75
percent. For Equity Z, we find:
E(RZ) = .055 + .075(0.80) = .1150 or 11.50%
The return given for Z is 10.5 percent, but according to the CAPM the
expected return of the equity should be 11.50 percent based on its level of
risk. Equity Z plots below the SML and is overvalued. In other words, its
price must decrease to increase the expected return to 11.50 percent.
We can also answer this question using the reward-to-risk ratio. All assets
must have the same reward-to-risk ratio, that is, every asset must have
the same ratio of the asset risk premium to its beta. This follows from the
linearity of the SML in Figure 10.11. The reward-to-risk ratio is the risk
premium of the asset divided by its . This is also known as the Treynor
ratio or Treynor index. We are given the market risk premium, and we know
the of the market is one, so the reward-to-risk ratio for the market is
0.075, or 7.5 percent. Calculating the reward-to-risk ratio for Y, we find:
Reward-to-risk ratio Y = (.17 .055) / 1.50 = .0767
The reward-to-risk ratio for Y is too high, which means the equity plots
above the SML, and the equity is undervalued. Its price must increase until
its reward-to-risk ratio is equal to the market reward-to-risk ratio. For
equity Z, we find:
Reward-to-risk ratio Z = (.105 .055) / .80 = .0625
The reward-to-risk ratio for Z is too low, which means the equity plots
below the SML, and the equity is overvalued. Its price must decrease until
its reward-to-risk ratio is equal to the market reward-to-risk ratio.
We now need to set the reward-to-risk ratios of the two assets equal to
each other which is:
19. The expected return of a portfolio is the sum of the weight of each
asset times the expected return of each asset. So, the expected return of
the portfolio is:
E(Rp) = .40(.15) + .60(.16) = .156 or 15.6%
The variance is:
Var(portfolio) X A2 2A 2 X A X B AB X B2 2B
X A2 2A 2 X A X B A B AB X B2 2B
.42.32 .62.42 2(.4)(.6)(.3)(.4)(.6) .10656
The standard deviation is the square root of the variance:
Standard Deviation = 0.3264 or 32.64%
24. a.
The expected return of the portfolio is the sum of the
weight of each asset times the expected return of each asset, so:
E(RP) = wAE(RA) + wBE(RB)
E(RP) = .40(.15) + .60(.25)
E(RP) = .2100 or 21.00%
The variance of a portfolio of two assets can be expressed as:
2P = w 2A 2A + w 2B 2B + 2wAwBABA,B
2P = .402(.402) + .602(.652) + 2(.40)(.60)(.40)(.65)(.50)
2P = .24010
So, the standard deviation is:
= (.24010)1/2 = .4900 or 49.00%
b.
The expected return of the portfolio is the sum of the weight of each
asset times the expected return of each asset, so:
Siracha Siracha,m
m
So:
.33(.62)
1.364
.15
27. Here we need to use the debt-equity ratio to calculate the WACC. Doing
so, we find:
WACC = .18(1/1.60) + .10(.6/1.60)(1 .35) = .1369 or 13.69%
28. Here we need to find the pre-tax cost of debt. If the debt to assets
ratio is .23, then the equity to assets ratio is .77. We can now calculate the
pre-tax cost of debt.
WACC = .209 = .23rD(1-.27) + .77(.25)
Therefore rD is 9.83%
29. Here we have the WACC and need to find the debt-equity ratio of the
company. Setting up the WACC equation, we find:
WACC = .1150 = .16(E/V) + .085(D/V)(1 .35)
Rearranging the equation, we find:
.115(V/E) = .16 + .085(.65)(D/E)
Now we must realize that the V/E is just the equity multiplier, which is
equal to:
V/E = 1 + D/E
.115(D/E + 1) = .16 + .05525(D/E)
Now we can solve for D/E as:
.05975(D/E) = .0450
D/E = .7531
30. a.
The book value of equity is the book value per share
times the number of shares, and the book value of debt is the face value of
the companys debt, so:
BVE = 9.5M(5) = 47.5M
BVD = 75M + 60M = 135M
So, the total value of the company is:
V = 47.5M + 135M = 182.5M
And the book value weights of equity and debt are:
E/V = 47.5/182.5 = .2603
D/V = 1 E/V = .7397
b. The market value of equity is the share price times the number of
shares, so:
MVE = 9.5M(53) = 503.5M
Using the relationship that the total market value of debt is the price
quote times the par value of the bond, we find the market value of debt
is:
MVD = .93(75M) + .965(60M) = 127.65M
This makes the total market value of the company:
V = 503.5M + 127.65M = 631.15M
And the market value weights of equity and debt are:
E/V = 503.5/631.15 = .7978
D/V = 1 E/V = .2022
c. The market value weights are more relevant.
31. First, we will find the cost of equity for the company. The information
provided allows us to solve for the cost of equity using the CAPM, so:
RE = .052 + 1.2(.09) = .16 or 16.00%
Next, we need to find the YTM on both bond issues. Doing so, we find:
P1 = 930 = 40(PVIFAR%,20) + 1,000(PVIFR%,20)
R = 4.54%
YTM = 4.54% 2 = 9.08%
P2 = 965 = 37.5(PVIFAR%,12) + 1,000(PVIFR%,12)
R = 4.13%
YTM = 4.13% 2 = 8.25%
To find the weighted average after-tax cost of debt, we need the weight of
each bond as a percentage of the total debt. We find:
When there are corporate taxes, the overall cost of capital for the firm
declines the more highly leveraged is the firms capital structure. This is
M&M Proposition I with taxes.
25. Since Unlevered is an all-equity firm, its value is equal to the market value
of its outstanding shares. Unlevered has 10 million shares outstanding, worth
80 per share. Therefore, the value of Unlevered:
VU = 10,000,000(80) = 800,000,000
Modigliani-Miller Proposition I states that, in the absence of taxes, the
value of a levered firm equals the value of an otherwise identical unlevered
firm. Since Levered is identical to Unlevered in every way except its capital
structure and neither firm pays taxes, the value of the two firms should be
equal. Therefore, the market value of Levered plc should be 800 million
also. Since Levered has 4.5 million outstanding shares, worth 100 per
share, the market value of Levereds equity is:
EL = 4,500,000(100) = 450,000,000
The market value of Levereds debt is 275 million. The value of a levered
firm equals the market value of its debt plus the market value of its equity.
Therefore, the current market value of Levered is:
VL = B + S
VL = 275,000,000 + 450,000,000
VL = 725,000,000
The market value of Levereds equity needs to be 525 million, 75 million
higher than its current market value of 450 million, for MM Proposition I to
hold. Since Levereds market value is less than Unlevereds market value,
Levered is relatively underpriced and an investor should buy shares in the
firm.
26. To find the value of the levered firm, we first need to find the value of
an unlevered firm. So, the value of the unlevered firm is:
VU = EBIT(1 tC)/R0
VU = (35,000)(1 .28)/.14
VU = 180,000
The value of the equity is the residual value of the company after the
bondholders are paid off. If the low-volatility project is undertaken, the
firms equity will be worth Kc0 if the economy is bad and CHK20,000 if
the economy is good. Since each of these two scenarios is equally
probable, the expected value of the firms equity is:
Expected value of equity with low-volatility project = .50(CHK0) + .
50(CHK20,000)
Expected value of equity with low-volatility project = CHK10,000
And the value of the company if the high-volatility project is undertaken
will be:
Expected value of equity with high-volatility project = .50(CHK0) + .
50(CHK30,000)
Expected value of equity with high-volatility project = CHK15,000
c.
d.
c.
to
bondholders
.60(150,000,000)
5.16(2/3) = 3.44
b.
5.16(1/1.08) = 4.78
c.
5.16(1/1.20) = 4.30
d.
5.16(3/2) = 7.74