FNCE20001

Business Finance
Assignment 2
Prepared by
Dr. Vincent Gr
egoire
Department of Finance
Faculty of Business and Economics
The University of Melbourne
Semester 1, 2016

Administrative Arrangements

Due date: 5pm on Monday May 16, 2016

Format: This individual assignment consists of 15 multiple choice questions and is worth
7.5% of your overall grade. While students are encouraged to discuss the assignment and
to share information sources, the assignment must be your own work. Besides providing
you with timely feedback on your performance in this subject, this assignment will also
help you prepare for the final exam.
Where to submit: Your responses should be entered on LMS before 5pm on Monday
May 16, 2016. The submission form will be available at least one week prior to the deadline. Failure to enter your answers during that period will result in a zero mark being
recorded for this assignment as the solutions will be posted on LMS the following day.
The subject coordinator will not make any exceptions to this rule. The Student Portal is
the only way to apply for Special Consideration. See the my.unimelb website for detailed
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information relating to who can apply for Special Consideration and the process for making
an application.
Once you access the assignment via the LMS you will have one hour to
enter your responses to all questions. So, you need to make sure that you
have worked through the assignment questions and that you have your answers
available for input. Realistically speaking, it should not take you more than
ten or so minutes to enter your answers. Make sure that you provide answers
to all the questions and save your responses before logging out of the LMS! If
you have any issues with accessing the LMS or the assignment, you need to
contact the LMS team ASAP. Do not wait until the last minute as the system
tends to get too crowded just before the assignment shuts down and you might
not be able to log in or enter your answers in the last 5-10 minutes.
Solutions: Please do not ask your tutor, a pit stop tutor, or the online tutor
for hints and/or suggestions on the assignment as they have been instructed
not to provide any assistance on assessments. Suggested answers to the questions
will be posted on the LMS after marking is done. If you do not follow any of the answers,
please check with your tutor, a pitstop tutor, the online tutor or the lecturer.

Questions

Question 1. Companies that use WACC as the required rate of return for all investment
projects, regardless of risk, will tend to:
a) Incorrectly reject high risk project.
b) Incorrectly accept high risk projects.
c) Incorrectly accept low risk projects.
d) Increase in risk and value over time.
Solution to Question 1: The correct answer is b.
For low risk projects, incorrectly using the WACC (higher than the actual required rate
of the project) can cause the firm to incorrectly reject low risk projects over time.
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For high risk projects, incorrectly using the WACC (lower than the actual required rate
of the project) can cause the firm to incorrectly accept high risk projects over time.
Over time, this will cause the firm to increase in risk and decrease in value.
Question 2. You are analysing an investment project with conventional cash flows (only
one sign change). Using the IRR method, you find that you are indifferent to accepting
the project or not. The NPV of the project is:
a) Negative
b) Positive
c) Zero
d) The project has no NPV.
Solution to Question 2: The correct answer is c.
Using the IRR method, the firm is indifferent to accepting the project or not when the
IRR is equal to the required rate of return. The IRR is the discount rate that makes the
NPV equals to 0, so this means the NPV of the project must be 0.
Question 3. A manufacturing company is trying to decide between the following two
mutually exclusive projects:, with their respective projected cash flows:
Year

Machine A

Machine B

-12,000

-18,000

6,500

8,500

6,000

9,000

7,000

9,500

The company requires that all accepted projects have a payback less than three years
and produce a minimum rate of return of 11%. What should the company do and why?
a) Project I should be accepted but Project II should be rejected because only Project I
satisfies the payback period requirement.
b) Both projects should be accepted because they have IRRs which exceed the 11% requirement.
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c) Both projects should be accepted because they both have positive NPVs.
d) Project II should be accepted because it has the highest NPV.
Solution to Question 3: The correct answer is d.
Project I has an NPV of $3,843, IRR of 28.45% and payback period of 1.91 years.
Project II has an NPV of $3,909, IRR of 22.87% and payback period of 2.05 years. Both
projects are acceptable individually under the NPV, IRR and payback period method.
Since the projects are mutually exclusive, the company should pick the project with the
highest NPV, which is project II.
Question 4. A firms capital structure is currently all debt and common stock. The firm
is worth $100M today and would like to raise another $20M by issuing preference shares
with a fixed $5 p.a. dividend in perpetuity. The cost of equity is 10%, after-tax cost of
debt is 7%, and the current after-tax WACC is 8%. What should be the minimum price
per preference share if the firm does not want to raise its after-tax WACC?
a) $4.00
b) $62.50
c) $71.43
d) They could issue at any price.
Solution to Question 4: The correct answer is b.
If the firm does not want to raise its WACC, the maximum value for the cost of preference shares is 8% (the current value for the WACC). Therefore the minimum share price
is
P0 = Dp /kp = $5/0.08 = $62.50.
Question 5. The NPV of an investment project with conventional cash flows is -$20,500.
Which of the following is/are true if the project is assigned a 10.20% required rate of return?
I. The project will have a negative IRR.
II. The initial investment is more than the market value of the project
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III. If it exists, the IRR will not be unique.

a) None
b) I only.
c) II only.
d) II and III.
Solution to Question 5: The correct answer is c.
Since the NPV is negative, initial investment is more than the market value of the
project. We do not know the value of the IRR other than it is less than 10.20%. Since the
cashflows are conventional, the IRR is unique if it exists.
Question 6. A company owns a building that is totally paid for. This building has been
sitting idle for the past three years. Now the company is considering a project that would
use this building. Which of the following costs should be included in the analysis?
I. The current market value of the building.
II. The purchase price of the building.
III. Maintenance costs associated with the building over the last three years.
IV. The cost to change the plumbing required for the project.
a) II only.
b) I and III only.
c) II and III only.
d) I and IV only.

Solution to Question 6: The correct answer is d.

The maintenance costs associated with the building over the last three years is a sunk
cost and should not be included.
An implicit alternative option is to sell the building, so the current market value (not
the purchase price) of the building should be included.
The cost to change the plumbing required for the project will only be incurred if the
project is accepted, so it should be included.
Question 7. A firm is considering replacing an existing machine, and has narrowed down
the choice to two machines with lives of 4 and 5 years. The CFO is very busy, so she
delegated the final choices to three interns, Mark, Suzy and Joe. Mark thinks that since
the common multiple of 4 and 5 is only 20, they would reach a better decision using the
lowest common multiple method. Suzy thinks that since the machine will be replaced more
or less forever, they should instead use the perpetuity method to reach the best decision.
Joe thinks that it does not really matter which of the two method they use since they will
reach the same decision with both methods.
Which of the following is true?
a) Mark is right, Suzy and Joe are wrong.
b) Suzy is right, Mark and Joe are wrong.
c) Joe is right, Mark and Suzy are wrong.
d) The equivalent annuity value would give a better decision.
Solution to Question 7: The correct answer is c. The task that is delegated to them
is to figure out if the projects have positive NPV, in which case they should identify the
project with the highest NPV. Both methods will give exactly the same decision.
Question 8. Which of the following statements is (are) true concerning the internal rate
of return (IRR)?
I. The IRR method can produce multiple IRRs if the cash flows are nonconventional
(multiple sign changes).

II. When comparing projects, the IRR will give the same decision as NPV when the
projects have the same lives.
III. If two projects have the same IRR, then they also have the same NPV.
a) I only.
b) II only.
c) I and III only.
d) I, II and III.
Solution to Question 8: The correct answer is a.
II is false because NPV and IRR can give conflicting results even if the projects have
the same lives (see Lecture 14.1).
III is false. If two projects have the same IRR, it means that the same discount rate
makes their NPV equal to 0, but it doesnt mean that their NPV at the required rate of
return will be equal.
Question 9. A company is considering two mutually-exclusive projects with the following
projected after-tax cash-flows (assume earnings and cash flows are the same):
Year

Project A

Project B

-$120,000

-$10,000

$90,000

$5,000

$10,000

$5,000

$10,000

$12,000

$45,000

$12,000

The required rate of return is 10% and the required ARR based on initial investment
is 40%. What should the company do according to the NPV and ARR methodologies?
a) Choose Project A according to both NPV and ARR.
b) Choose Project B according to both NPV and ARR.
c) Choose Project A according to NPV and project B according to ARR.
d) Choose Project B according to NPV and project A according to ARR.
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Solution to Question 9: The correct answer is b.

The respective NPVs are $8,331.40 for Project A and $15,889.63 for Project B, so the
decision is to choose project B. The ARR based on initial investment for Project A is
((90 + 10 + 10 + 45)/4)/120 = 32%, which is lower than 40%, so this Project A is rejected
by the ARR method. The ARR for project B is ((5 + 5 + 12 + 12)/4)/10 = 85% so this
project would be chosen by the ARR method.
Question 10. Which of the following statements is (are) true?
I. For independent projects, the ARR and Payback period methodologies will always
give consistent decisions.
II. For independent projects, the payback period and IRR methodologies will always give
consistent decisions.
III. For mutually-exclusive projects, the IRR and NPV methodologies will always give
consistent decisions.
IV. For mutually-exclusive projects, the ARR and NPV methodologies will always give
consistent decisions.
a) I only.
b) III only.
c) II, III and IV.
d) None
Solution to Question 10: The correct answer is d.
None of these statements is true.
Question 11. Which of the following statements about inflation and capital budgeting is
true? Assume that expected inflation is positive.
a) For a project with an initial outlay and positive future cash flows, using a real discount
rate with nominal cash flows will produce an incorrect NPV that is greater than the
true NPV.
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b) For a project with an initial outlay and positive future cash flows, using a nominal
discount rate with real cash flows will produce an incorrect NPV that is greater than
the true NPV.
c) For a project with an initial outlay and positive future cash flows, using a real discount
rate with real cash flows will produce an incorrect NPV that is lower than the true
NPV.
d) For a project with an initial outlay and positive future cash flows, using a nominal
discount rate with nominal cash flows will produce an incorrect NPV that is lower than
the true NPV.
Solution to Question 11: The correct answer is a.
If you use nominal expected cash flows with a real expected discount rate the NPV so
calculated will be higher than it should be as the discount rate does not discount the cash
flows for expected inflation even though the expected cash flows include expected inflation.
If you use real expected cash flows with a nominal expected discount rate then the NPV
so calculated will be lower than it should be since you discount the cash flows for expected
inflation in effect twice (once by lowering the expected cash flows by expected inflation to
get the real expected cash flows, then again when you discount by the nominal discount
rate which includes expected inflation).
If you use nominal expected cash flows with a nominal expected discount rate then the
NPV should be correct and be the same as if you use real expected cash flows with a real
expected discount rate.
Question 12. Assume that a firm is financed by 60 percent equity, 10 percent preference
shares and the remainder by debt. The corporate tax rate is 30 percent. The before-tax
costs of capital for debt, preference and equity capital are 6 percent, 12 percent and 18
percent, respectively.
The firm is considering three independent projects: projects A, B and C with IRRs of
10%, 12% and 14% respectively. These projects have conventional cash flows and the same
risk as the firms current operations. Which of these projects should it accept?
a) Only Project A.
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b) Only Project C.
c) Projects A and B.
d) Projects B and C.
Solution to Question 12: The correct answer is b.
The weight of debt in the capital structure of the firm is kd = 1kp ke = 1.1.6 = 0.3.
The after-tax WACC is :
k0 = kd (1 tc )(D/V ) + kp (P/V ) + ke (E/V )
= 0.06 (1 .3) 0.3 + 0.12 0.1 + 0.18 0.6
= 13.26%
Only Project C has an IRR greater than 13.26%, so the firm should only accept Project
C.
Question 13. The initial cost of a machine required for a project is $60,000. It has a
useful life of 10 years and will be depreciated on a straight-line basis over 10 years. The
machine is expected to generate before-tax operating cash flows of $10,000 per year life
and the effective corporate tax rate is 30%. The appropriate discount rate is 12% p.a.
after-tax. The company plans to sell the machine for $25,000 at the end of year 6. Which
of the following statements is true?
a) The project should be accepted because the NPV is $2,340.
b) The project should be rejected because the NPV is -$13,302.
c) Depreciation is irrelevant because it is not a cash flow.
d) The after-tax salvage value in year 6 is $24,700.
Solution to Question 13: The correct answer is d.
The NPV of the project is -$11,305.83, so a) and b) are false. Depreciation is not
irrelevant because it reduces taxes, so c) is false. The book value of the machine in year 6
is $60,000(1-6/10)=$24,000, so the gain is $25,00-$14,000=$1,000. The tax payable from
that gain is .3*$1,000=$300, so the total after-tax cash flow is $24,700.
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Question 14. Which of the following statements is (are) true?

I. For two mutually exclusive projects with conventional cash flows, the net present
value and internal rate of return methods select different projects if the required rate
of return is greater than the discount rate at which the two net present value profiles
intersect.
II. If a projects cash flows (including the investment) are positive after discounting them
by the required rate of return, then it may be accepted if there are no better alternatives.
III. If multiple positive NPV projects are independent, then the project with the lowest
net present value is rejected.
IV. If the projects are mutually exclusive, then all projects with a net present value greater
than zero are accepted.
a) I only.
b) II only.
c) II and III only.
d) I and IV only.
Solution to Question 14: The correct answer is b.
I is false; IRR and NPV give the same decision if the required rate of return is greater
than the discount rate at which the two net present value profiles intersect. III is false; if
projects are independent then the one with the lowest NPV is only rejected if its NPV is
negative. IV is false; you can only select at most one project if they are mutually exclusive.
Question 15. The forecast net cash flows of two mutually exclusive projects, A and B,
are shown in the following table.

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Year

Project A

Project B

-$60,000

-$30,000

$26,000

$10,000

$25,000

$12,000

$30,000

$17,500

$26,200

$11,600

$13,200

$8,450

The NPV and IRR methods must give conflicting decisions for these projects if:
a) The required rate of return is less than 31% pa.
b) The required rate of return is greater than 28% pa.
c) The required rate of return is between 28% pa and 31% pa.
d) None of the above.
Solution to Question 15: The correct answer is d.
Since the crossover point, which is 34%, is higher than both projects IRRs (31% and
28% respectively), the ranking would be different for required rate of returns higher than
34%. However, for required rate of returns higher than 34%, both projects have negative
NPV so the ranking does not matter, the NPV and IRR methods would reject the project.
Note: The crossover point can be found by computing the IRR of the differencial project
(A-B) or (B-A). (see lecture on incremental IRR).

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