BAFI 355

Homework Assignment 3
Due at the beginning of class on October 6, 2!"
#ubmit a neatl$ han%written an%&or a well'aligne% com(uter (rintout of
solutions to
the following 9 questions.
Show all the steps for problems or write concise answers for conceptual questions
While you may discuss with others, you must submit your own answers to all the questions.
1. Suppose ABC frm invests $1 million today on a new construction project. The
project will generate annual cash fows o $1!"#""" (er(etuall$. The
appropriate annual discount rate or the project is 1" percent.
a. $hat is the pay%ac& period or the project' ( ABC frm desires to have
a ma)imum o 1" year pay%ac& period# should the project %e adopted'
%. $hat is the *+, o the project'
-. As Chie .inancial /0cer o 12. frm# you are o3ered the ollowing two
mutually e)clusive projects. Suppose the appropriate discount rate or these
projects is 1! percent.
Year Project A Project B
" 4!#""" 41""#"""
1 5#!"" 6!#"""
- 5#!"" 6!#"""
a. $hat are the (77s o these two projects'
%. Compute the incremental (778 that is# the (77 o the di3erence o the cash
fows %etween the - projects.
c. Based on your answer to part 9%: a%ove# which project should you choose'
d. According to the *+, rule# which o these two projects should %e adopted'
1
5. Consider the ollowing cash fows on two mutually e)clusive projects that
re;uire an annual return o 1! percent. $or&ing in the fnancial planning
department# you are trying to compare di3erent investment criteria to arrive
at a sensi%le choice o these two projects.
Year Project A Project B
" 46""#""" 41#<""#"""
1 -="#""" 1#"""#"""
- 5!"#""" =""#"""
5 5""#""" >""#"""
a. ( your decision rule is to accept the project with a greater (77# which
project should you choose'
%. Since you are ully aware o the (77 rule?s pitalls# you calculate the
incremental (77 or the cash fows. Based on this calculation# which
project should you choose'
c. To %e prudent# you compute the *+, or %oth projects. $hich project
should you choose' (s it consistent with the incremental (77 rule'
@. A company is considering 5 mutually e)clusive projects 9that is# at most one
project can %e accepted: with the ollowing cash fows8
Aear " 1
+roject 1 4-"" B-6!
+roject - 41!" B-1"
+roject 5 41-! B1==
a. Calculate the (77 or each o the a%ove cash fows# without using 2)cel.
%. Aour company presents its capital %udgeting proposals in terms o (77. The
re;uired rate o return is -"C. Dse just the (77 rule to show which project 9i
any: should %e chosen.
!. A frm is considering - mutually e)clusive projects# the cash fows rom which are
as ollows8
+roposal A
Aear " 1 - 5 @
Cash fow 4!> 4! @" @! 6!
+roject B
Aear " 1 - 5 @
Cash fow 4<< 5" @" @! 6!
The cost o capital is 1=C.
a. Show how to determine whether the company should choose A or B# or neither#
using *+,.
2
%. Show how to determine whether the company should choose A or B# or neither#
using (77.
6. Two mutually e)clusive projects A and B have the ollowing cash fows8
Aear A B
" 46""#""" 41#<""#"""
1 -="#""" 1#"""#"""
- 5!"#""" =""#"""
5 5""#""" >""#"""
The cost o capital is 1!C.
a: ( your decision rule is to accept the project with the higher (77# what is your
decision'
%: But you are aware o the pitall o using the (77 o each project alone when
ma&ing your decision. So correcting or the pitall and still using only (77#
what is your decision' Show all intermediate steps.
c) Dsing the *+, rule# what is your choice' Show all calculations.
=. Two mutually e)clusive projects ( and (( have the ollowing cash fows8
Aear ( ((
" 45"#""" 4!#"""
1 1!#""" -#<""
- 1!#""" -#<""
5 1!#""" -#<""
The cost o capital is 1"C.
a) ( your decision rule is to accept the project with the higher +rofta%ility (nde)
9+(:# what is your decision' Show all calculations.
b) Dsing the *+, rule# what is your choice' Show all calculations.
c) $hy are the answers to 9a: and 9%: di3erent'
<. Consider the ollowing cash fows o - mutually e)clusive 9EF2: projects.
Assume that the appropriate $ACC or cost o capital or discount rate is 1"C.
Year Project A Project B
" 45"" 41!""
1 @"" 11""
- 1"" <""
5 1"" @""
a. Based on the pay%ac& period# which project is %etter'
%. Based on the *+,# which project is %etter'
c. Based on the (77# which project is %etter'
d. $hich project# i any# should %e chosen'
3
>. GAH (nc. has a project with the ollowing cash fows8
Year Cash Flows ($)
" 4<#"""
1 @#"""
- 5#"""
5 -#"""
a. Compute the internal rate o return 9(77: on the project.
%. Suppose the appropriate discount rate is < percent. Should the project %e
adopted according to the (77 rule'
4