Math

University of the West Indies -Open Campus

MGMT2023 Financial Management

Semester 1 2015/2016

Tutorial Sheet # 4

Due November 15, 2015, 11:55 PM ECT

1. Suppose you want to invest in a $100,000 project that you expect to provide cash inflows of

$50,000 in the first year, $25,000 in the second and $20,000 per year thereafter, what is the

payback period? [enter up to 2 decimal places] (2 points)

2. You are asked to evaluate two projects X and Y. The cash flow for each is listed below.

The firm’s cost of capital is 12%.

a) Calculate the NPV of each project? [rounded to the nearest tens](4 points)

b) Which project would you select? (1 point)

c) Compute the IRR for project X. [up to two decimal places] (2 points)

Based on the IRR criterion, should project X be accepted? (1 point)

d) Compute the IRR for project Y. [up to two decimal places] (2 points)

Based on the IRR criterion, should project Y be accepted? (1 point)

3. FITCO Inc. is a Pharmaceutical Company which is considering investing in a new equipment

for the production of pain-reliever medicine for individuals who suffer from cardio vascular

diseases. The new equipment will costs $2,000,000, and an additional $100,000 is needed for

installation. The equipment which falls into the MACRS 5-yr class, would be sold after five

years for $150,000.

Year X Y

0 (10,000) (10,000)

1 6,500 3,500

2 3,000 3,500

3 3,000 3,500

4 1,000 3,500

The equipment will generate additional annual revenues of $965,000, and will have annual

operating expenses of $300,000. An inventory investment of $60,000 is required during the

life of the project. FITCO is in the 30 percent tax bracket, and has the same risk as the firm’s

existing assets. Its existing cost of capital is 15 percent.

a) Calculate the initial outlay of the project. [no units and points] (2 points)

b) Calculate the annual after-tax operating cash flow for Years 1 -5. [no units and

points] (5 points)

c) Determine the terminal year non-operating cash flow in year 5. [no units and

points] (4 points)

d) What is the project NPV? [rounded to the nearest hundred] (3 marks)

e) What is the estimated Internal Rate of Return (IRR) of the project? [up to two

decimal places] (2 marks)

f) Should the project be accepted based on the IRR criterion? (1 marks)

4. What is the company’s cost of equity capital if CCC’s common stock has a beta of 2.0, a

risk-free rate of 6.0 percent and the expected return on the market is 12 percent? (3 points)

5. Merrill Lynch Limited has the following information and a tax rate of 30 percent. .

Debt 2,000, 6 percent coupon bonds outstanding, $1,000 par value, 12 years to maturity, selling for 95 percent of par, the bonds make semi-annual payments

Common stock 250,000 shares outstanding, selling for $55 per share; the beta is 1.20

Preferred stock 12,000 shares of 6 percent preferred stock outstanding, currently selling for $110 per share

Market 6 percent market risk premium and 4 percent risk-free rate

Determine the company’s WACC by computing the following:

(a) Total Market value for the company. [no units and points] (4 points)

(b) After-tax Cost of Debt. (Rounded to 3 decimal places) (2 points)

(c) Cost of Common Stock (Rounded to 3 decimal places) (2 points)

(d) Cost of Preferred Stock (Rounded to 3 decimal places) (2 points)

(e) WACC (Rounded to 3 decimal places) (3 points)

6. Which of the following statements are true? Select 4 that apply. (4 points)

a) Discounted payback method of capital appraisal ignores cash flows beyond the

discounted payback period.

b) The net present value is found by discounting all positive cash flows at the project’s cost

of capital.

c) The project is accepted if the IRR is less than the project’s cost of capital.

d) The IRR is the discount rate which forces the present value of a project’s future cash

flows to equal the future value of its costs.

e) Firms often choose among mutually exclusive projects on the basis of the present value

of future costs.

f) To use the CAPM approach in capital budgeting, we estimate the firm’s beta, multiply

this by the market risk premium and add the firm’s risk premium to the risk-free rate to

obtain the firm’s cost of retained earnings or cost of equity.

g) The best proxy for the risk-free rate is the yield on treasury bonds.

h) Floatation costs are generally material when looking at its effect on the after-tax cost of

debt.

END OF TUTORIAL SHEET