Advanced Corporate Finance Leonidas Rompolis

EXERCISES -2 (SOLUTIONS)

Chapter 6, Practice Questions

1. See the table below. We begin with the cash flows given in the text, Table 6.6, line 8,
and utilize the following relationship:
Real cash flow = nominal cash flow/(1 + inflation rate)t
Here, the nominal rate is 20 percent, the expected inflation rate is 10 percent, and the
real rate is given by the following:

(1 + rnominal) = (1 + rreal) × (1 + inflation rate)

1.20 = (1 + rreal) × (1.10)
rreal = 0.0909 = 9.09%

As can be seen in the table, the NPV is unchanged (to within a rounding error).

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Net Cash Flows -12,600 -1,484 2,947 6,323 10,534 9,985 5,757 3,269
Net Cash Flows (Real) -12,600 -1,349 2,436 4,751 7,195 6,200 3,250 1,678
NPV of Real Cash Flows (at 9.09%) = $3,804

13. In order to solve this problem, we calculate the equivalent annual cost for each of the
two alternatives. (All cash flows are in thousands.)
Alternative 1 – Sell the new machine: If we sell the new machine, we receive the cash
flow from the sale, pay taxes on the gain, and pay the costs associated with keeping the
old machine. The present value of this alternative is:
30 30 30 30 30
PV1 = 50 -[0.35(50 - 0)] - 20 - - - - -
1.12 1.12 1.12 1.12 1.125
2 3 4

5 0.35 (5 - 0)
+ 5
- =-$93.80
1.12 1.125
The equivalent annual cost for the five-year period is computed as follows:
PV1 = EAC1 × [annuity factor, 5 time periods, 12%]
–93.80 = EAC1 × [3.605]
EAC1 = –26.02, or an equivalent annual cost of $26,020

Alternative 2 – Sell the old machine: If we sell the old machine, we receive the cash flow
from the sale, pay taxes on the gain, and pay the costs associated with keeping the new
machine. The present value of this alternative is:
20 20 20 20 20
PV2 = 25 - [0.35(25 - 0)] - - - - -
1.12 1.12 1.12 1.12 1.125
2 3 4

20 30 30 30 30 30
- 5
- 6
- 7
- 8
- 9
-
1.12 1.12 1.12 1.12 1.12 1.1210

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Advanced Corporate Finance Leonidas Rompolis

5 0 .35 (5 - 0)
+ 10
- =-$127.51
1.12 1.1210
The equivalent annual cost for the ten-year period is computed as follows:
PV2 = EAC2 × [annuity factor, 10 time periods, 12%]
–127.51 = EAC2 × [5.650]
EAC2 = –22.57, or an equivalent annual cost of $22,570
Thus, the least expensive alternative is to sell the old machine because this alternative has
the lowest equivalent annual cost.

15. The table presents the NFV for the five following years. The present values of these
NFV are calculated by:
NFVt
NPVt =
(1 + OCC) t
For example, if the investment starts the first year the NPV1 would be:
NFV1 1.64
NPV1 = = = 1.43
1 + OCC 1.14
when the OCC = 14% and
NFV1 1.64
NPV1 = = = 1.36
1 + OCC 1.2
when the OCC = 20%. Following the same procedure for the other years we construct the
following table:

Year of investment
0 1 2 3 4 5
OCC = 14% 1 1.43 1.76 1.85 1.84 1.77
OCC = 20% 1 1.36 1.5902 1.5914 1.50 1.37

In both cases the optimal time to invest is year 3.

17. a. PVA = $66,730 (Note that this is a cost.)

8,000 8,000 8,000 8,000
PVB = 50,000 + + + +
1.06 1.062 1.063 1.064
PVB = $77,721 (Note that this is a cost.)
Equivalent annual cost (EAC) is found by:
PVA = EACA × [annuity factor, 6%, 3 time periods]
66,730 = EACA × 2.673
EACA = $24,964 per year rental

PVB = EACB × [annuity factor, 6%, 4 time periods]

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Advanced Corporate Finance Leonidas Rompolis

77,721 = EACB × 3.465

EACB = $22,430 per year rental

b. Annual rental is $24,964 for Machine A and $22,430 for Machine B. Borstal
should buy Machine B.

c. The payments would increase by 8 percent per year. For example, for Machine A,
rent for the first year would be $24,964; rent for the second year would be ($24,964
× 1.08) = $26,961; etc.

1. a. The following table presents the cash flows for capital budgeting:

1 2 3 4 5
CI 90,000 93,600 97,344 101,238 105,287
COUT 75,000 79,500 84,270 89,263 94,686
CI – COUT 15,000 14,100 13,074 11,912 10,601
(1 – τc) 9,000 8,460 7,844 7,147 6,361
τcDep 3,200 3,200 3,200 3,200 3,200
CF 12,200 11,660 11,044 10,347 9,561

The NPV is:

12, 200 11, 660 11, 044 10,347 9,561
NPV = −40, 000 + + + + + = $4,172
1.08 1.082 1.083 1.084 1.085
and the project should be accepted.
b. We must discount nominal cash flows to nominal rates. Therefore, we must
calculate the nominal OCC. This is equal to:
rnom = (1 + 0.08)(1 + 0.06) − 1 = 14.48%
The NPV of the project is now: NPV = - $1,779, and the project should be rejected.

2. The first step is to compute the NPVs of the projects:

⎡ 1 1 ⎤
NPVA = −48, 000 + 20, 000 ⎢ − 5⎥
= $17, 485
⎣ 0.16 0.16 × 1.16 ⎦
Similarly, NPVB = $6,900, NPVC = $17,328 and NPVD = $19,750.
The second step is to assume constant scale replication and to calculate:
⎡ (1 + k) N ⎤
NPV(N, ∞) = NPV(N) ⎢ ⎥
⎣ (1 + k) − 1 ⎦
N

The results are:

NPVA (N, ∞) = $33,366 (best)
NPVB (N, ∞) = $7, 735 (worst)
NPVC (N, ∞) = $22, 407
NPVD (N, ∞) = $22,139

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3. a. The NPVs of the project are:

6 6
NPVA = −10 + + = 0.41
1.10 1.102
and
6.55 6.55 6.55
NPVB = −10 + + + = 0.41
1.4 1.42 1.43
b.
⎛ 1.102 ⎞
NPVA ( N, ∞ ) = 0.41⎜ ⎟ = 2.36
⎝ 1.10 − 1 ⎠
2

⎛ 1.403 ⎞
NPVB ( N, ∞ ) = 0.41⎜ ⎟ = 0.65
⎝ 1.40 − 1 ⎠
3

c. The EAVs are

EAVA = 0.1⋅ NPVA ( N, ∞ ) = 0.236
EAVB = 0.4 ⋅ NPVB ( N, ∞ ) = 0.260
d. Project A should be accepted, following the NPV ( N, ∞ ) criterion. The EAV cannot
be used, since the two projects have different risk.

5
12, 000
4. a. NPVA = −40, 000 + ∑ t
= 3, 260
t =1 1.12
and NPVB = 3,840, NPVC = 5,200 and NPVD = 6,725.
Following the NPV rule the best project is D, while the worst is A.
⎡ (1 + k) N ⎤
b. NPVA (N, ∞) = NPVA ⎢ ⎥ =7,535 , where k = 12%
⎣ (1 + k) − 1 ⎦
N

Similarly we have, NPVB (N, ∞) = 8,876 , NPVC (N, ∞) = 7, 669 and

NPVD (N, ∞) = 9,918 . Project D should be selected.
c. We start by computing the PVI for each project. These are,
PVIA = 1.08, PVIB = 1.15, PVIC = 1.13 and PVID = 1.22.
We have a budget constraint of $70,000. Therefore, the only combination that we
cannot use is project A and C.
Assume the projects A and B. Then we have that:
40, 000 25, 000 5, 000
PVI A,B = 1.08 + 1.15 + 1.0 = 1.099
70, 000 70, 000 70, 000
Similarly we calculate the PVI of all other combinations and we observe that the
maximum is for C and D equal to PVIC,D = 1.169. Thus, projects C and D should be
selected for investment.

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Advanced Corporate Finance Leonidas Rompolis

5. We have that
DVt ( Vt − C ) k 100, 000 (100, 000 ln t − 50, 000 ) 0.15
= ⇒ =
dt 1 − e − kt t 1 − e−0.15t
The solution is approximately 3.55 years.

6. The NPVA = 20.41, NPVB = -23.55 and NPVC = 15.86.

The problem is set as follows:
max ( 20.41X1 − 23.55X 2 + 15.86X3 )
subject to:
30X1 + 50X 2 + 80X 3 ≤ 120
30X1 + 20X 2 + 30X 3 ≤ 50
10X1 + 20X 2 + 50X 3 ≤ 50
0 ≤ X j ≤ 1, j = 1, 2,3
The solution is: X1 = 1, X2 = 0 and X3 = 0.667.
The NPV of the selected combination of project is NPV = 30.99. We select project A,
which has the maximum NPV, while we reject project B which has a negative NPV.