Corporate Finance

Tutorial 1 Questions

Corporate Finance
Tutorial 1: Time Value of Money and Project Appraisal
Questions
Exercises on Time Value of Money
1.

2.

A Japanese company is considering investing in Singapore. It intends to make a

bid to the Singapore government to participate in the development of a leisure
resort in Jurong West, the profits of which will be realised at the end of 5 years.
The resort is expected to produce S$5,000,000 in cash to the Japanese company at
that time. Other than the bid at the outset, no other cash flows will occur, as the
Singapore government will reimburse the Japanese company for all cost. If the
Japanese company requires an annual return of 20%, what is the maximum bid it
should make for the participation right if interest is compounded
(a)

annually?

(b)

semi-annually?

(c)

quarterly?

You are considering making an offer to buy some land for $25,000. Your offer
will be to pay $5,000 down and for the seller to carry a contract for the remaining
$20,000. You would like to pay off the contract over 6 years at an interest rate of
12% per year. For the first year you wish to pay interest only each month. For the
remaining 5 years, you are willing to pay off the contract in equal monthly
instalments. What will be your monthly payment for years 2 through 6 if the seller
agrees to your terms?

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3.

Tutorial 1 Questions

A financial manager has been presented with two proposals for automating an
assembly process. Plan X requires an immediate investment of $75,000 in assets
which will have a salvage value of $15,000 at the end of its 15 years lifespan. It
further requires an additional investment of $25,000 at the end of the third year.
Plan Y will require an initial investment of only $30,000 and two additional
modifications. The first modification will be done at the end of the fifth year at a
cost of $40,000 and the second at the end of the tenth year at cost of another
$40,000. It would have a salvage value of $30,000 at the end of its 15 years
lifespan.
The annual out-of-pocket operating disbursements for the two alternatives would
be as follows:
Year
13
4 15

Plan X
$7,500 per year
$9,000 per year

Year
15
6
7 15

Plan Y
$4,500 per year
$6,000 per year
$9,500 per year

The companys cost of capital is 10% p.a.

Which plan would you recommend the firm to adopt?

Exercises on Net Present Value

Assume an interest rate of 5% p.a. Compute the NPV of each of the following projects,
and state whether each project should be accepted or not.
1.

Project A has an immediate cost of $5,000, generates $1,000 for each of the next
six years and zero thereafter.

2.

Project B costs 1,000 immediately, generates cash flows of 600 in year 1, 300
in year 2 and 300 in year 3.

3.

Project C costs 10,000 and generates 6,000 in year 1. Over the following years,
the cash flows decline by 2,000 each year, until the cash flow reaches zero.

4.

Project D costs 1,500 immediately. In Year 1 and Year 2 it generates 1,000. In

Year 2 there is a further cost of 2,000. In Year 3, 4 and 5 the project generates
revenues of 1,500 per annum.

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Sample Examination Questions on NPV

1.

The Toyundai Motor Company has the opportunity to invest in new production
line equipment, which would have a working lifetime of 10 years. The new
equipment would generate the following increases in Toyundais net cash flows.
In the first year of usage the new plant would decrease costs by $200,000. For the
following six years the cost saving would fall at a rate of five per cent per annum.
In the remaining years of the equipments lifetime, the annual cost saving would
be $140,000. Assuming that the cost of the equipment is $1,000,000 and that
Toyundais cost of capital is 10 per cent, calculate the NPV of the project. Should
Toyundai take on the investment?
(15%)

2.

Describe two methods of project evaluation other than NPV. Discuss the
weaknesses of these methods when compared to NPV.
(10%)

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Lee Ltd
Lee Ltd is considering changing its plant and has spent $7,000 on a work-study project
covering the proposed changes. The study revealed:
(1)

Existing plant has an expected life of 5 years at which date it would have a zero
scrap value. It could be sold for $40,000 in 2 years time.

(2)

At present the plant produces 2,000 units per annum, each yielding a contribution
of $10.

(3)

New plant would take five years to build and would cost $200,000 payable in 5
equal annual installments. This would produce 4,000 units per annum after the
existing plant's closure and still contribute $10 per unit. The life of the plant
would be 20 years, at the end of which time it would have a zero scrap value.

(4)

Fastbuild plc. has offered to construct the plant in 2 years but at a cost of
$280,000 payable in two annual instalments. Performance would not be affected
by the speed of construction.

Assume that
i)

Cost of capital is 7%

ii)

If the plant were not replaced, the company could invest at the cost of the capital.

iii)

That manufacture of the product according to the company's strategic plans will
cease at the end of either the existing or the new plant's life.

iv)

All receipts and payments take place on the last day of each year.

Required:
a)

A report indicating whether construction of the new plant is worthwhile, and if so,
over 2 or 5 years.
(12 marks)

b)

Discuss whether you think the assumptions on which your calculations are based
are reasonable and whether there are any other factors which might affect the
decision.
(9 marks)

c)

Assuming a 10% error in each of the predictions identify the most sensitive
variable influencing your decision in a) with your evidence.
(4 marks)

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FE 2007 Zone B Question B6 (Part a)

Describe the NPV-rule, the internal rate of return criterion, and the payback rule
for investment. What are the relative advantages and disadvantages of these
rules?
(8 marks)

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FE2009 Zone B Question A3(a)

Cranberry Plc is considering to purchase a new machine. It has
identified two possible models which have the following initial costs and
expected cash savings per year:
C0
Model A - 200,000
Model B - 200,000

C1
90,000
190,000

C2
70,000
55,000

C3
110,000

Model A has a useful life of 3 years while model B can last for 2 years. Neither of
these models have any residual value at the end of their useful economic lives.
Cranberry plc has been discounting similar investments at 10% per annum. It
intends to replace the chosen model each time when it reaches the end of its
useful life. If the above cash flows to these two models will be unchanged in the
foreseeable future, which model should the company choose to make economic
sense? Explain clearly the reasoning behind and any reservation for your
calculations.
(10 marks)

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FE2010 Zone B Question A3

Solar Products Plc has just developed a new product to be called RTC3. The
total development cost amounts to 480,000. The company is now considering
whether to put it into production. The following information is available.
Production of RTC3 will require the purchase of new machinery at a cost of
1,200,000 payable immediately. This machinery is specific to the production
of RTC3 and will be obsolete and valueless when that production ceases. The
machinery has a production life of 4 years and a normal production capacity of
30,000 units per annum. The production capacity can be increased to 40,000
units per year for a one-off modification cost of 50,000. This modification
expense is payable at the beginning of the year in which the company wants to
increase the production capacity. Once the modification is made, the
production capacity will stay at 40,000 per year. If the demand exceeds
capacity, the company will only be able to sell the products up to the
maximum capacity at the price stated below.
The companys policy is to depreciate this type of machinery using the
straight-line method.
Production costs per unit of RTC3 are estimated as follows:
Materials
Labour
Overheads

8
6
20

Overheads include the allocated depreciation charge on the new machinery,

otherwise they are all related to the production of RTC3.
The selling price of RTC3 will be 60 per unit. Demand is expected to fluctuate
in accordance with the market condition. A market survey, which was
commissioned prior to the production, has the following findings:
Market
condition
Good
Average
Bad

Probability
%
30
50
20

Year 1
units
30,000
25,000
18,000

Year 2
units
32,000
26,000
17,000

Year 3
units
35,000
27,000
15,000

Year 4
units
40,000
28,000
15,000

The cost of the market survey has not been paid and it amounts to 5,000. The
realisation of the market condition in each year is independent from each
other.

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The companys effective tax rate is 30% and the capital allowances are at 25%
of the written down value of the machinery at the beginning of each year. Any
unrelieved capital allowance will be given in full in the year of disposal. Tax
is payable in the same year to which it is related. To keep things simple
assume the net cash flow per year is treated as the taxable profit before capital
allowance.
The after-tax cost of capital for the company is 15%.
(a)

Calculate the after-tax net present value of this project.

(b)

Explain why net present value is a more preferable technique for capital
budgeting than other methods.
(8 marks)

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(17 marks)