Australian School Of Business

FINS1613: Business Finance

Tutorial Quiz 2
Practice Questions from Semester 1 2013 and Semester 1 2014

Name: SAMPLE SOLUTION

Student number: z0000000

Tutorial:

Instructions:

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Other Data. If you are taking a quiz preprinted with your student
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(c) Answer all questions using the generalised answer sheet. Clearly fill in
the response oval using a 2B pencil.

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Information:

1. Time allowed: 20 minutes

2. Grading:

(a) Total marks available: 100 marks

(b) Correctly recording your student ID on the Generalised Answer sheet
is worth 4 (four) marks.
(c) All questions are graded on a correct/incorrect basis. There is no
penalty for answering a question incorrectly.

3. Unless otherwise specified, each question is independent of the others and

assumptions from one question do not carry over to the others.

4. Use of a calculator is allowed.

5. Some useful equations are printed below.

(a) Standard annuity:

 
1 1
Annuity V aluet = Ct+1 × 1−
r (1 + r)n

(b) Growing annuity:

  n 
1 1+g
Growing Annuity V aluet = Ct+1 × 1−
r−g 1+r

GOOD LUCK!
 Annuity Factors
r=1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
n=1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502
11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944
1

13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235
14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109
16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694
21 18.8570 17.0112 15.4150 14.0292 12.8212 11.7641 10.8355 10.0168 9.2922 8.6487 8.0751 7.5620
22 19.6604 17.6580 15.9369 14.4511 13.1630 12.0416 11.0612 10.2007 9.4424 8.7715 8.1757 7.6446
23 20.4558 18.2922 16.4436 14.8568 13.4886 12.3034 11.2722 10.3711 9.5802 8.8832 8.2664 7.7184
24 21.2434 18.9139 16.9355 15.2470 13.7986 12.5504 11.4693 10.5288 9.7066 8.9847 8.3481 7.7843
25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 8.4217 7.8431
26 22.7952 20.1210 17.8768 15.9828 14.3752 13.0032 11.8258 10.8100 9.9290 9.1609 8.4881 7.8957
27 23.5596 20.7069 18.3270 16.3296 14.6430 13.2105 11.9867 10.9352 10.0266 9.2372 8.5478 7.9426
28 24.3164 21.2813 18.7641 16.6631 14.8981 13.4062 12.1371 11.0511 10.1161 9.3066 8.6016 7.9844
 Annuity Factors
r= 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24%
n= 1 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 0.8264 0.8197 0.8130 0.8065
2 1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278 1.5095 1.4915 1.4740 1.4568
3 2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065 2.0739 2.0422 2.0114 1.9813
4 2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887 2.5404 2.4936 2.4483 2.4043
5 3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906 2.9260 2.8636 2.8035 2.7454
6 3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255 3.2446 3.1669 3.0923 3.0205
7 4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046 3.5079 3.4155 3.3270 3.2423
8 4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372 3.7256 3.6193 3.5179 3.4212
9 5.1317 4.9464 4.7716 4.6065 4.4506 4.3030 4.1633 4.0310 3.9054 3.7863 3.6731 3.5655
10 5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925 4.0541 3.9232 3.7993 3.6819
11 5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271 4.1769 4.0354 3.9018 3.7757
12 5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392 4.2784 4.1274 3.9852 3.8514
2

13 6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327 4.3624 4.2028 4.0530 3.9124
14 6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106 4.4317 4.2646 4.1082 3.9616
15 6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755 4.4890 4.3152 4.1530 4.0013
16 6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296 4.5364 4.3567 4.1894 4.0333
17 6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746 4.5755 4.3908 4.2190 4.0591
18 6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122 4.6079 4.4187 4.2431 4.0799
19 6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435 4.6346 4.4415 4.2627 4.0967
20 7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696 4.6567 4.4603 4.2786 4.1103
21 7.1016 6.6870 6.3125 5.9731 5.6648 5.3837 5.1268 4.8913 4.6750 4.4756 4.2916 4.1212
22 7.1695 6.7429 6.3587 6.0113 5.6964 5.4099 5.1486 4.9094 4.6900 4.4882 4.3021 4.1300
23 7.2297 6.7921 6.3988 6.0442 5.7234 5.4321 5.1668 4.9245 4.7025 4.4985 4.3106 4.1371
24 7.2829 6.8351 6.4338 6.0726 5.7465 5.4509 5.1822 4.9371 4.7128 4.5070 4.3176 4.1428
25 7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476 4.7213 4.5139 4.3232 4.1474
26 7.3717 6.9061 6.4906 6.1182 5.7831 5.4804 5.2060 4.9563 4.7284 4.5196 4.3278 4.1511
27 7.4086 6.9352 6.5135 6.1364 5.7975 5.4919 5.2151 4.9636 4.7342 4.5243 4.3316 4.1542
28 7.4412 6.9607 6.5335 6.1520 5.8099 5.5016 5.2228 4.9697 4.7390 4.5281 4.3346 4.1566
Bonds

1. Removalists of Junk Inc. is issuing a new fifteen-year bond with a coupon

rate of 5.9%. Coupons are semi-annual. The risk-free yield to maturity on
similar term bonds trading in the market is 6.9% and Removalists of Junk
has a credit spread of 2.3%. The yield to maturity on Removalists of Junk’s
bonds is and the bond will trade at .

(a) 6.9%, par

(b) 9.20%, a discount (less than par)
(c) 9.20%, a premium (greater than par)
(d) 4.60%, a discount (less than par)
(e) 4.60%, a premium (greater than par)

Answer: b

The yield to maturity on a risky bond is the risk-free yield plus the credit
spread, 6.9% + 2.3% = 9.2%. Since the coupon rate, 5.9%, is less than the
yield to maturity, the bond trades at a discount.

2. The zero coupon bond yield curve shows that the one-, two-, and three-year
interest rates are 4.0%, 5.9%, and 7.6%, respectively. What is the price of
a three-year bond with a face value of $600 and coupons of 15% paid
annually?

(a) $648.42
(b) $720.67
(c) $481.63
(d) $643.01
(e) $715.25

Answer: b
The coupon payments will be $90 per year (15% of the face value of $600).
Therefore, the bond will pay $90 at t = 1, $90 at t = 2 and $690 at t = 3.
Discount each of these at the respective discount rates on the yield curve to
find the bond price:

Coupon Coupon Coupon + F ace V alue

P rice = + 2
+
1 + r1 (1 + r2 ) (1 + r3 )3
90 90 690
= + 2
+
1.04 1.059 1.0763
= 720.67

3
3. Suppose a seven year, $1,000 bond with semi-annual coupons has a price of
$1,202.92 and a yield to maturity of 10% APR. What is the bond’s coupon
rate?

(a) 12.2%
(b) 13.5%
(c) 10.4%
(d) 11.3%
(e) 14.1%

Answer: e

The bond pays semi-annually for seven years making n = 14 payments in

total. The semi-annual rate yield, y = 10%/2 = 5%. Using the bond pricing
equation (based on the annuity formula) means that:

F ace value
P rice = CP N × Annuity F actor(y discount rate, n periods) +
(1 + y)n

where CPN is the semi-annual coupon payment. The annuity factor from
the tables is 9.8986. Plugging in to the equation above:
1000
1202.92 = CP N × 9.8986 +
(1.05)14

Solving, CP N = $70.5. The annual coupon is twice the semi-annual coupon,

$141. The coupon rate is the annual coupon as a percent of face value,
141/1000 = 14.1%.

4
4. Removalists of Junk Inc. is issuing a new eleven-year bond at a face value of
$1,000 with a coupon rate of 8.5%. Coupons are semi-annual. The risk-free
yield to maturity on similar term bonds trading in the market is 4% and
Removalists of Junk has a credit spread of 12%. What should be the price
of Removalists of Junk’s bond?

(a) $1,394.22
(b) $617.47
(c) $646.39
(d) $792.18
(e) $683.62

Answer: b
The bond pricing equation using yield to maturity is
 
1 1 F ace V alue
P rice = Coupon × 1− +
y (1 + r)n (1 + r)n

To find each input:

ˆ n: Since this is an 11 year bond with semi-annual payments, it will

make 22 payments.
ˆ y: If the risk-free rate is 4% and firm has a credit spread of 12%, then
the YTM on the bonds is 16%. This is an APR, to get the (semi-annual)
period rate divide by 2. y = 0.08
ˆ Coupon: The coupon payments are found by multiplying the coupon
rate by the face value and dividing by 2 (for semi-annual payments).
Therefore, Coupon payments are $42.50 every six months.

The annuity factor for r = 0.08 and n = 22 is 10.2007. Substituting into

the pricing equation gives:

F ace V alue
P rice = Coupon × 10.2007 +
(1 + r)n
1000
= 42.50 × 10.2007 +
1.082 2
= 617.47

5
5. The short-term (overnight) interest rate is currently 5%. Assume the follow-
ing:

i. The reserve bank of Australia adjusts interest rates in order to slow a

rapidly expanding economy;
ii. Investors expect that interest rates will decrease in the future; and
iii. Interest rates reflect typical investor concerns about the high level of
price sensitivity to interest rate movements in long-term bonds.

Which of the following yield curves reflects all the assumptions above?

(a) (b)
10 10
Yield (%)

Yield (%)
5 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10

Maturity (Years) Maturity (Years)

(c) (d)
10 10
Yield (%)

Yield (%)

5 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10

Maturity (Years) Maturity (Years)

(e)
10
Yield (%)

0
0 2 4 6 8 10

Maturity (Years)

Answer: b

The Reserve Bank adjusts interest rates to slow a rapidly expanding econ-
omy by increasing the short-term interest rate. Therefore, the short-term
rate must increase and be greater than 5%. Then, if interest rates are ex-
pected to decrease, yield to maturity on short-term bonds will be less than
5%. Finally, investors generally demand higher yields on long-term bonds.
So, the yield curve must start above 5%. Then, it decreases for medium-term
bonds and increases for long-term bonds.

6
 Equity

6. A company expects to have earnings in fiscal year 2014 of $52.30 when it

will payout 59% of earnings. The firm reinvests retained earnings in new
projects with an expected return on investment of 8% per year. What is the
expected dividend for fiscal year 2015 if it pays out 45% of earnings in that
fiscal year?

(a) $27.45
(b) $24.31
(c) $24.83
(d) $13.89
(e) $23.36

Answer: b

The growth rate in earnings, g, from 2014 to 2015 is equal to the expected
return on investment multiplied by the retention rate. If the firm pays out
59% of earnings, it holds on to 41% of earnings. Therefore, the growth rate
is

g = Retention × Return on new investment

= 0.41 × 0.08
= .0328

This means earnings for the 2015 fiscal year is EPS in 2014 with 3.28%
growth: EP S2015 = EP S2014 × (1 + g) = 52.30 × 1.0328 = $54.01544. If the
firm pays out 45% of earnings in 2015, then the dividend in 2015 is

Div2015 = EP S2015 × P ayout2015 = 54.01544 × 0.45 = 24.306948 ≈ 24.31.

7
7. Prescott Pharmaceuticals will pay an annual dividend of $1.50 one year from
now. Analysts expect this dividend to grow at 18.6% per year thereafter until
the end of year twelve. After then, growth will level off at 4.0% per year.
According to the dividend-discount model, what is the value of a Prescott
Pharmaceuticals share if the firm’s equity cost of capital is 11.0%?

(a) $50.97
(b) $43.62
(c) $58.06
(d) $65.56
(e) $72.62

Answer: d

The dividend payments consist of a twelve year growing annuity and a grow-
ing perpetuity making the first payment in year 13. The value of the annuity
is given by:
  n 
1 1+g
Growing Annuity V aluet=0 = Ct=1 × 1−
r−g 1+r
"  1 #
1 1.186
= 1.50 × 1− 2
.11 − .186 1.11
= 23.96

Valuing the perpetuity requires determining the dividend in year 13. If the
year 1 dividend grows by 18.6% each year until year 12, then it grows over 11
years. So, Div12 = Div1 × 1.18611 = 1.5 × 1.18611 = 9.7954. The dividend in
year 13 is the year 12 dividend after growing by 4%, Div13 = Div12 × 1.04 =
10.1872. The growing perpetuity gives the value of the perpetuity as of year
12.
Div1 3 10.1872
P epetuity V aluet=12 = = = 145.5314
r − gterminal .11 − .04
The present value of the perpetuity is found by discounting the value above
twelve years to t = 0.
P erpetuity V aluet=12 145.5314
P erpetuity V aluet=0 = = = 41.60
(1 + r)12 1.1112

The total price of the stock is

P rice = Growing Annuity V aluet=0 + P erpetuity V aluet=0

= 23.96 + 41.60
= 65.56

8
8. In one year’s time, a firm is expected to have earnings of $90 million. The
firm is expected to pay dividends of $35.5 million and spend $11.6 million on
share repurchases. Earnings are expect to grow by 16.7% annual fifteen times
(until t=16 ). After this period, earnings are expected to remain constant in
perpetuity. The firm’s cost of equity capital is 12.8% and the dividend and
repurchase rates are expected to stay constant in perpetuity. What is the
market value of the firm’s equity?

(a) $1,370.78 million

(b) $1,550.16 million
(c) $1,335.10 million
(d) $1,415.86 million
(e) $1,513.89 million

Answer: d
Use a total payout, 2-stage growth model. This consists of a growing annuity
from t = 1 to t = 16 and a constant perpetuity with first payment at t =
17. The total payout in one year’s time is the total of the dividends and
repurchases, 35.5 + 11.6 = $47.1million. If earnings grow at 16.7% and the
payout rates stay constant, then the growth in payouts will be 16.7%. The
first 16 years of payouts can be priced using a constant growth annuity model.
To find the terminal value of the constant perpetuity, first get the cash flow
at t = 17. The t = 1 payout will grow 15 times to t = 16. Therefore, the
total payout at t = 16 is 47.1 × 1.16715 = 477.62. This will be the same at
t = 17, so P ayout17 = 557.38. Now use a 2-stage growth model

M V Equity = Growing Annuity + P erpetuity with f irst payment at t = 17

 16 !
1 1+g 1 P ayout17
= P ayout1 × 1− +
r−g 1+r (1 + r)16 r
 16 !
1 1.167 1 477.62
= 47.1 × 1− +
0.128 − 0.167 1.128 (1.128)16 0.128
= 872.70 + 543.16
= 1415.86

9
9. Soylent Corp expects earnings this year (at t=1 ) of $6.14 per share. It
currently has a share price of $49.93. The firm pays 33% of earnings in
dividends and reinvests 67% of earnings in new projects. Reinvested earnings
provide a return on new investment of 13.7%. However, due to a disappearing
customer base, Soylent Corp will soon announce that the firm will begin
paying out 61% of all earnings as dividends, retaining 39% for investment
in new projects. What will be the share price after this announcement?
Investors are not expecting the firm to change its payout policy.

(a) $49.93
(b) $47.45
(c) $43.87
(d) $42.18
(e) $45.60

Answer: b
If the current dividend rate is 33% and the firm is expected to have earnings
of $6.14, then the expected dividend is 0.33 × 6.14 = 2.0262. If the current
reinvestment rate is 67% and the return on new investment is 13.7%, then
the current growth rate in earnings is g = 0.67 × 0.137 = 0.09179. Use the
current price to find the cost of equity rE :

Div1 2.0262
P = → 49.93 =
rE − g rE − 0.09179
Solving gives rE = 0.132371. At the new dividend rate, the expected dividend
this year will be 0.61 × 6.14 = 3.7454. At the new retention rate of 39%, the
firm’s growth in earnings will drop to 0.39 × 0.137 = 0.05343. Substituting
into the pricing equation gives the new share price

3.7454
Pnew = = 47.45
0.132371 − 0.05343

10
 Investment Decision Rules

10. Texas LLP chooses projects using a two-step investment decision rule. First,
all projects are screened by payback period. All projects that payback in
more than 30 years are rejected. Second, projects that pay back in 30 years
or less are evaluated for Net Present Value. The firm invests in any positive
NPV project from the second step. Which of the following is true about this
investment decision rule?

(a) Since the payback period is very long, the time value of money does
not factor into the investment decision.
(b) With a long payback period, the firm will end up investing only in risky
projects.
(c) By combining the two rules, project risk is overemphasised in the deci-
sion relative to the time value of money.
(d) By combining the two rules, the time value of money is overemphasised
in decision relative to project risk.
(e) The firm may fail to maximise firm value.

Answer: e

The firm may reject positive NPV projects that take a long amount of time
to payback through the initial screening process. In so doing, the firm does
not maximise value.

11. A project requires an initial capital expenditure at time t=0 of $3,017. It

then generates constant annual cash flows for the next 23 years of $350 with
the first payment due at t=1. After this period, payments grow at a rate of
3% annually and are paid in perpetuity.
The net present value of this project is 2,829 dollars at an annual discount
rate of 7.0%. Given this, the IRR of the project is .

(a) equal to 7.0%

(b) greater than 7.0%
(c) less than 7.0%
(d) not enough information
(e) there are multiple IRRs

Answer: b
The first part of the question establishes that the cash flows are conventional.
This means that as the discount rate increases, the NPV of the project de-
creases (the NPV profile slopes down and to the right). If the NPV is posi-
tive at 7%, then the IRR (the discount rate where the NPV is zero) must be
greater than 7%.

11
12. Paranoia Inc. is evaluating a number of exterminators to control a chu-
pacabra infestation. Jackalope Pest Control offers a 5 year contract requir-
ing an upfront payment (t=0 ) of $190,000 and quarterly payments of $2,300
with the first payment due in three months. What is the annual cost of the
service as an equivalent annual annuity at a discount rate of 24.0% EAR
(effective annual rate)?

(a) $47,200
(b) $86,167
(c) $74,675
(d) $70,407
(e) $79,198

Answer: e

First, compute the present value of the contract’s cash flows. It consists
of an initial payment and a 5-year quarterly annuity. The discount rate
of 24% EAR must be converted to a periodic rate to value the annuity:
1
quarterly rate = (1.24) 4 − 1 = 0.05525. Then, the annuity, which makes 20
quarterly payments of $2,300 has a value of:

1 20
 
1
$2300 × 1− = $27429
0.05525 1.05525

Adding the initial payment of $190,000 gives the total contract cost in present
value terms of $217,429.
Second, convert the present value of the contract into an equivalent annual
annuity. Divide the present value cost by the annuity factor for a 5 year
contract and a 24% discount rate. Since this is an annual cost, the annuity
factor is for 5 periods at the annual rate, 24%. In the annuity table, the
annuity factor is 2.7454. Therefore, the equivalent annual annuity cost is
217429/2.7454 = $79, 198.

12
13. CGA Technologies Inc. is offering your firm a 18-year contract to create and
host a sixteen-color website on its collection of Pentium computers. The
contract terms specify annual payments of $15,000 for 9 years followed by
annual payments of $25,950 for another 9 years (In other words, payments
of $15,000 from t=1 to t=9 and payments of $25,950 from t=10 to t=18 ).
The annual discount rate is 4.0%.
What is the equivalent annual annuity cost of the web hosting service?

(a) $19,519
(b) $40,950
(c) $16,083
(d) $17,594
(e) $22,531

Answer: a
To compute the equivalent annual annuity, first compute the NPV of the cash
flows. The cash flows consist of a 9-year annuity of cash flows of $15000
followed by another 9-year annuity with cash flows of $25950. The annuity
factor for a 9-year annuity at a discount rate of 4% is 7.4353. Applying this
to the $15000 gives a present value of 7.4353*15000 = 111529.5. The second
part is a 9-year annuity starting at t=10. Applying the annuity factor to the
cash flow of 25950 gives a t=9 value. So, discount this nine periods to get
the present value.

7.4353 × 25950
T otal present value = 7.4353 × 15000 + = 247090.82
1.049

The equivalent annual annuity cost is the 18-year annuity that has the same
present value. The annuity factor for an 18-year annuity at a discount rate
of 4% is 12.6593. Therefore,

247090.82
Equivalent annual annuity = = 19518.52 ≈ 19519
12.6593

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14. A firm recently evaluated a project requiring an initial capital expenditure
at time t=0 of $34,900. Annual cash flows from the project were expected
to begin in 1 year at t=1 with $6,000 and grow at a rate g in perpetuity.

Although the firm did not know what precise discount rate to use
for project valuation, it was certain that correct annual discount
rate was between 19% and 21%. It was able to approve the
project for all discount rates in that range. Given this, what must
be true about the growth rate of the cash flows?

(a) g is greater than 1.8%

(b) g is less than 3.8%
(c) g is greater than 3.8%
(d) g is less than 1.8%
(e) g is greater than 0.8%

Answer: c

This project has conventional cash flows, so the internal rate of return de-
cision rule can be used. If the firm approved the project, then it must be
that the IRR was greater than all potential discount rates used in valuation.
Worst case would be that the IRR was 21%. If that was the case, then NPV
at 21% was $0. Using the NPV expression for an initial cash flow and a
growing perpetuity means that at a 21% discount rate
6000 6000
−34900 + = 0 → .21 − g = → g = 3.8%
.21 − g 34900

If the growth rate was less than 3.8%, then the firm may have wanted to
reject the project for some discount rates. Therefore, it must be that g is
greater than 3.8%.

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