Week 7__T_Q

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University of the Fraser Valley *

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Finance

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Apr 3, 2024

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FIN222 Week 7_T CH8: RQ5 P3,7,9,10(a),12,23,25,26,30 (10 Questions, 18 parts) RQ5 Under what conditions will the IRR rule and the NPV rule give the same accept/reject decision? P3 Your storage firm has been offered $100 000 in one year to store some goods for one year. Assume your costs are $95 000, payable immediately, and the cost of capital is 8%. Should you take the contract? P7 Your factory has been offered a contract to produce a part for a new printer. The contract would last for three years and your cash flows from the contract would be $5 million per year. Your up-front setup costs to be ready to produce the part would be $8 million. Your cost of capital for this contract is 8%. a. What does the NPV rule say you should do? b. If you take the contract, what will be the change in the value of your firm? P9 John Howard reportedly was paid $400 000 to write his book Lazarus Rising. The book took three years to write. In the time he spent writing, Howard could have been paid to make speeches. Given his significance as Australia’s second-longest serving prime minister, assume that he could earn $300 000 per year (paid at the end of the year) speaking instead of writing. Assume his cost of capital is 10% per year. a. What is the NPV of agreeing to write the book (ignoring any royalty payments)? b. Assume that, once the book was finished, it was expected to generate royalties of $200 000 in the first year (paid at the end of the year) and these royalties were expected to decrease at a rate of 30% per year in perpetuity. What is the NPV of the book with the royalty payments?
P10 Superfast Bikes is thinking of developing a new composite road bike. Development will take six years and the cost is $200 000 per year. Once in production, the bike is expected to make $300 000 per year for 10 years. The cash inflows begin at the end of year 7. Assume that the cost of capital is 10%. a. Calculate the NPV of this investment opportunity. Should the company make the investment ? P 12 You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The sign will cost $5000 and will be posted for one year. You expect that it will generate additional revenue of $500 per month. What is the payback period? 23 You are considering making a movie. The movie is expected to cost $10 million up-front and take a year to make. After that, it is expected to make $5 million in the year it is released and $2 million for the following four years. What is the payback period of this investment? If you require a payback period of two years, will you make the movie? Does the movie have positive NPV if the cost of capital is 10%? P25 You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its revenue will grow at 2% per year for every year after that. a. Which investment has the higher IRR? b. Which investment has the higher NPV when the cost of capital is 7%? c. In this case, when does picking the higher IRR give the correct answer as to which investment is the better opportunity? P 26 You are considering the following two projects and can only take one. Your cost of capital is 11%.
0 1 2 3 4 A -$100 25 30 40 50 B -$100 50 40 30 20 a. What is the NPV of each project at your cost of capital? b. Establish the equation from which IRR (Internal Rate of Return) is solved. (Note: Students have been directed to change the question this way.) IRR A = 14.7% IRR B = 17.8% (Given to students) c. Establish the equation from which the cross-over point is solved. (Note: Students have been directed to change the question this way. The cross-over point of 5.6% has been given to students.) d. What should you do? 30 Fabulous Fabricators needs to decide how to allocate space in its production facility this year. It is considering the following contracts: NPV($) Use of Facility (%) A 2 million 100 B 1 million 60 C 1.5 million 40 a. What are the profitability indices of the projects? b. What should Fabulous Fabricators do?
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