Extra practice exam 2

1)
Using the tax shield approach to calculating OCF, we get:
OCF = (Sales Costs)(1 tC) + tCDepreciation
OCF = [($5.25 2,000) ($2.40 2,000)](1 .40) + .40($10,000 / 5)
OCF = $4,220.00
So, the NPV of the project is:
NPV = $10,000 + $4,220.00(PVIFA13%,5)
NPV = $4,842.72

2)
a.
We have a special case where the portfolio is equally weighted, so we can sum the returns of each asset
and divide by the number of assets. The expected return of the portfolio is:
E(RP) = (.13 + .032) / 2
E(RP) = .0810, or 8.10%

b.
We need to find the portfolio weights that result in a portfolio with a of 0.99. We know the of the riskfree asset is zero. We also know the weight of the risk-free asset is one minus the weight of the stock
since the portfolio weights must sum to one, or 100 percent. So:
P = .99 = XS(1.80) + (1 wS)(0)
.99 = 1.8XS + 0 0XwS
XS = .99 / 1.80
XS = .55
And, the weight of the risk-free asset is:
XRf = 1 .55 = .45

c.
We need to find the portfolio weights that result in a portfolio with an expected return of 9 percent. We
also know the weight of the risk-free asset is one minus the weight of the stock since the portfolio weights
must sum to one, or 100 percent. So:
E(RP) = .09 = .13XS + .032(1 XS)
.09 = .13XS + .032 .032XS

.058 = .098XS
XS = .5918
So, the of the portfolio will be:
P = .5918(1.80) + (1 .5918)(0)
P = 1.065

d.
Solving for the of the portfolio as we did in part a, we find:

P = 3.60 = XS(1.80) + (1 XS)(0)

XS = 3.60 / 1.80 = 2
XRf = 1 2 = 1
The portfolio is invested 200% in the stock and 100% in the risk-free asset. This represents borrowing
at the risk-free rate to buy more of the stock.

6)
Using the tax shield approach, the OCF at 90,000 units will be:
OCF = [(P v)Q FC](1 tC) + tC(D)
OCF = [($35 28)(90,000) $240,000](1 .30) + .30($600,000 / 4)
OCF = $318,000
We will calculate the OCF at 91,000 units. The choice of the second level of quantity sold is arbitrary and
irrelevant. No matter what level of units sold we choose, we will still get the same sensitivity. So, the OCF
at this level of sales is:
OCF = [($35 28)(91,000) $240,000](1 .30) + .30($600,000 / 4)
OCF = $322,900
The sensitivity of the OCF to changes in the quantity sold is:
Sensitivity = OCF/Q = ($318,000 322,900) / (90,000 91,000)
OCF/Q = +$4.90
OCF will increase by $4.90 for every additional unit sold.

7)
The profitability index is defined as the PV of the cash inflows divided by the PV of the cash outflows.
The cash flows from this project are an annuity, so the equation for the profitability index is:

PI = C(PVIFAR,t) / C0
PI = $84,000(PVIFA13%,7) / $385,000
PI = .965
The project should not be accepted because the PI is less than 1.
Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

CFo
C01
F01

0
$84,000
7

I = 13%
NPV CPT
$371,499.28
PI = $371,499.28 / $385,000 = .965

8)
We will use the bottom-up approach to calculate the operating cash flow for each year. We also must be
sure to include the net working capital cash flows each year. So, the net income and total cash flow each
year will be:
Year 0

Year 1

Year 2

Year 3

Year 4

$ 13,000

$ 13,500

$ 14,000

$ 11,000

2,800

2,900

3,000

2,200

6,250

6,250

6,250

6,250

EBT
Tax

$ 3,950
1,501

$ 4,350
1,653

4,750
1,805

$ 2,550
969

Net
incom
e

$ 2,449

$ 2,697

2,945

$ 1,581

9,195

$ 7,831

310

1,390

$ 8,885

$ 9,221

Sales
Costs
Depr
eciatio
n

OCF
Capit
al
spendi
ng
NWC

$ 8,699

$ 8,947

$ 25,000

Incre

$ 25,310

310

360

$ 8,339

410

$ 8,537

mental
cash
flow

The NPV for the project is:

NPV = $25,310 + $8,339 / 1.10 + $8,537 / 1.10 2 + $8,885 / 1.103 + $9,221 / 1.104
NPV = $2,299.78

9)
To calculate the payback period, we need to find the time it takes for the project to recover its initial
investment. The cash flows in this problem are an annuity, so the calculation is simpler. If the initial cost
is $1,850, the payback period is:
Payback = 2 + ($500 / $675) = 2.74 years
There is a shortcut to calculate the payback period when the future cash flows are an annuity. Just divide
the initial cost by the annual cash flow. For the $3,600 cost, the payback period is:
Payback = $3,600 / $675 = 5.33 years
The payback period for an initial cost of $5,500 is a little trickier. Notice that the total cash inflows after
eight years will be:
Total cash inflows = 8($675) = $5,400
If the initial cost is $5,500, the project never pays back. Notice that if you use the shortcut for annuity
cash flows, you get:
Payback = $5,500 / $675 = 8.15 years
This answer does not make sense since the cash flows stop after eight years, so again, we must
conclude the payback period is never.

10)
We need to calculate the NPV of the two options, go directly to market now, or utilize test-marketing first.
The NPV of going directly to market now is:
NPV = CSuccess (Prob. of Success) + CFailure (Prob. of Failure)
NPV = $35,000,000(.60) + $13,000,000(.40)
NPV = $26,200,000
Now we can calculate the NPV of test-marketing first. Test-marketing requires a $1.40 million cash
outlay. Choosing the test-marketing option will also delay the launch of the product by one year. Thus,
the expected payoff is delayed by one year and must be discounted back to Year 0.
NPV = C0 + {[CSuccess (Prob. of Success)] + [CFailure (Prob. of Failure)]} / (1 + R)t
NPV = $1,400,000 + {[$35,000,000(.90)] + [$13,000,000(.10)]} / 1.10
NPV = $28,418,182

The company should test-market first with the product since that option has the highest expected payoff.

11) a.
The pretax cost of debt is the YTM of the companys bonds, so:
P0 = $910 = $30(PVIFAR%,28) + $1,000(PVIFR%,28)
R = 3.510%
YTM = 2 3.510% = 7.02%

b.
The aftertax cost of debt is:
RD = .0702(1 .35)
RD = .0456, or 4.56%

c.
The aftertax rate is more relevant because that is the actual cost to the company

12)
First we will calculate the annual depreciation of the new equipment. It will be:
Annual depreciation charge = $530,000 / 5
Annual depreciation charge = $106,000
The aftertax salvage value of the equipment is:
Aftertax salvage value = $50,000(1 .34)
Aftertax salvage value = $33,000
Using the tax shield approach, the OCF is:
OCF = $310,000(1 .34) + .34($106,000)
OCF = $240,640
Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting this
project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction
in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project,
we will have a cash outflow to restore the NWC to its level before the project. We also must include the
aftertax salvage value at the end of the project. The IRR of the project is:
NPV = 0 = $530,000 + 65,000 + $240,640(PVIFAIRR%,5) + [($33,000 65,000) / (1 + IRR)5]
IRR = 42.42%

21)
We will find the EAC of the EVF first. There are no taxes since the university is tax-exempt, so the
maintenance costs are the operating cash flows. The NPV of the decision to buy one EVF is:
NPV = $7,700 $1,675(PVIFA8%,5)
NPV = $14,387.79
In order to calculate the equivalent annual cost, set the NPV of the equipment equal to an annuity with
the same economic life. Since the project has an economic life of five years and is discounted at 8
percent, set the NPV equal to a five-year annuity, discounted at 8 percent. So, the EAC per unit is:
EAC = $14,387.79 / (PVIFA8%,5)
EAC = $3,603.51
Since the university must buy five of the mowers, the total EAC of the decision to buy the EVF mower is:
Total EAC = 5($3,603.51)
Total EAC = $18,017.57
Note, we could have found the total EAC for this decision by multiplying the initial cost by the number of
mowers needed, and multiplying the annual maintenance cost of each by the same number. We would
have arrived at the same EAC.
We can find the EAC of the AEH mowers using the same method, but we need to include the salvage
value as well. There are no taxes on the salvage value since the university is tax-exempt, so the NPV of
buying one AEH will be:
NPV = $6,700 $1,675(PVIFA8%,8) + $700 / 1.088
NPV = $15,947.43
So, the EAC per mower is:
EAC = $15,947.43 / (PVIFA8%,8)
EAC = $2,775.09
Since the university must buy seven of the mowers, the total EAC of the decision to buy the AEH mowers
is:
Total EAC = 7($2,775.09)
Total EAC = $19,425.62
The university should buy the EVF mowers since the EAC is less negative.

24)
To find the EAC, we first need to calculate the NPV of the incremental cash flows. We will begin with the
aftertax salvage value, which is:
Taxes on salvage value = (BV MV)tC
Taxes on salvage value = ($0 28,000)(.34)
Taxes on salvage value = $9,520

Marke
t price
Tax on
sale
Afterta
x
salvage
value

28,000

9,520

18,480

Now we can find the operating cash flows. Using the tax shield approach, the operating cash flow each
year will be:

OCF = $10,600(1 .34) + .34($114,000 / 4)

OCF = $2,694.00

So, the NPV of the cost of the decision to buy is:

NPV = $114,000 + $2,694.00(PVIFA12%,4) + ($18,480 / 1.124)
NPV = $94,073.01
In order to calculate the equivalent annual cost, set the NPV of the equipment equal to an annuity with
the same economic life. Since the project has an economic life of four years and is discounted at 12
percent, set the NPV equal to a 4-year annuity, discounted at 12 percent.
EAC = $94,073.01 / (PVIFA12%,4)
EAC = $30,972.07

26)
Both projects only have costs associated with them, not sales, so we will use these to calculate the NPV
of each project. Using the tax shield approach to calculate the OCF, the NPV of System A is:
OCFA = $72,000(1 .35) + .35($228,000 / 4)
OCFA = $26,850
NPVA = $228,000 $26,850.00(PVIFA10%,4)
NPVA = $313,110.89
And the NPV of System B is:
OCFB = $66,000(1 .35) + .35($324,000 / 6)
OCFB = $24,000
NPVB = $324,000 $24,000.00(PVIFA10%,6)
NPVB = $428,526.26
If the equipment will be replaced at the end of its useful life, the correct capital budgeting technique is
EAC. Using the above NPVs, the EAC for each system is:
EACA = $313,110.89 / (PVIFA10%,4)
EACA = $98,777.34
EACB = $428,526.26 / (PVIFA10%,6)
EACB = $98,392.79
If the conveyor belt system will be continually replaced, we should choose System B since it has the less
negative EAC.

28) a.
The equation for the NPV of the project is:
NPV = $38,400,000 + $62,400,000 / 1.10 $11,400,000 / 1.10 2
NPV = $8,905,785.12
The NPV is greater than zero, so we would accept the project.

b.
The equation for the IRR of the project is:
0 = $38,400,000 + $62,400,000 / (1 + IRR) $11,400,000 / (1 + IRR) 2
From Descartes rule of signs, we know there are potentially two IRRs since the cash flows change signs
twice. From trial and error, the two IRRs are:
IRR = 79.02% and 41.52%
When there are multiple IRRs, the IRR decision rule is ambiguous. Both IRRs are correct, that is, both
interest rates make the NPV of the project equal to zero. If we are evaluating whether or not to accept
this project, we would not want to use the IRR to make our decision.
Calculator Solution:
Note: Intermediate answers are shown below as rounded, but the full answer was used to
complete the calculation.

CFo
C01
F01
C02
F02
I = 10%
NPV CPT
$8,905,785.12

$38,400,000
$62,400,000
1
$11,400,000
1

CFo
C01
F01
C02
F02

$38,400,000
$62,400,000
1
$11,400,000
1

IRR CPT
41.52%

Financial calculators will only give you one IRR, even if there are multiple IRRs. Using trial and error, or a
root solving calculator, the other IRR is 79.02%.