Chapter 9 - Home Work

CORPORATE FINANCE
ASSIGNEMENT – CHAPTER 9
Faisel Mohamed Pallikkattil

Calculating AAR [LO4]
6. You’re trying to determine whether to expand your business by building a new manufacturing
plant. The plant has an installation cost of $12 million, which will be depreciated straight-line to
zero over its four-year life. If the plant has projected net income of $1,854,300, $1,907,600,
$1,876,000, and $1,329,500 over these four years, what is the project’s average accounting
return (AAR)?
ARR = Average net profit/Average investment
Average net profit
= 1,854,300 + 1,907, 600 + 1,876,000 +1,329,500
= 6967400/4
= 1,741,850
Average investment
= 12000000/2
= 6,000,000
Therefore, the ARR is
= 1,741,850/6,000,000
= 0.29 or 29%
Calculating NPV [LO1]
8. For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a
required return of 11 percent, should the firm accept this project? What if the required return is
25 percent?
NPV = Cash flow / (1 + r) i
NPV @ 11%
Period Cash flow PV Computation
0 -28000 -28000
1 12000 10810.81 12000/(1.11)
2 15000 12174.34 15000/(1.11)2
3 11000 8043.11 11000/(1.11)3
NPV 3028.26
NPV @ 25%
0 -28000 -28000
1 12000 9600 12000/(1.25)
2 15000 9600 15000/(1.25)2
3 11000 5632 11000/(1.25)3
NPV -3168.00
Therefore, according to NPV decision rule the firm should accept the project at a required rate of
11% and if the required rate is 25% the firm should reject the project.
Calculating NPV and IRR [LO1, 5]
9. A project that provides annual cash flows of $17,300 for nine years’ costs $79,000 today. Is
this a good project if the required return is 8 percent? What if it’s 20 percent? At what discount
rate would you be indifferent between accepting the project and rejecting it?
NPV = Cash flow / (1 + r) i
NPV @ 8%
0 -79000 -79000
1 ““ 16018.52 79000/1.08
2 ““ 14831.96
3 ““ 13733.30
4 ““ 12716.02
5 ““ 11774.09
6 ““ 10901.93
7 ““ 10094.38
8 ““ 9346.65
9 ““ 8654.31
NPV 29071.16
NPV @ 20%
0 -79000 -79000
1 ““ 14416.67 79000/1.20
2 ““ 12013.89
3 ““ 10011.57
4 ““ 8342.98
5 ““ 6952.49
6 ““ 5793.73
7 ““ 4828.11
8 ““ 4023.43
9 ““ 3352.86
NPV -9264.27
Based to NPV decision rule the firm should accept the project at a required rate of 8% and if the
required rate is 20% the firm should reject the project.
IRR = (FV/PV)1/N – 1
Comparing Investment Criteria [LO1, 2, 3, 5, 7]
17. Consider the following two mutually exclusive projects:
a. Payback Period
Project A
= 350000/153750
Payback period is 2.28 years
Project B
= 50000/20025
Payback period is 3.5 years
Therefore, when we use payback period method Project A is accepted, because it pays back
sooner than Project B.
b. Discounted Payback
Project A at return 15%
Period Cash flow DCF Cumulative
0 -350000 -350000
1 45000 39130 -310870
2 65000 12013.89 -261720
3 65000 10011.57 -218982
4 440000 8342.98 32590
= 3 + (2/4)
= 3.5 years
Project B at return 15%
Period Cash flow DCF Cumulative
0 -50000 -50000
1 24000 20870 -29130
2 22000 16635 -12495
3 19500 12822 326
= 2 + (1/3)
= 2.3 years
Using discounted payback criterion Project B is acceptable because it pays back sooner than A.
c. Using NPV criterion

Project A
NPV @ 15%
0 -350000 -350000
1 45000 39130.43 45000/1/15
2 65000 49149.34
3 65000 42737.85
4 440000 251572.33
NPV 32589.95
Project B
NPV @ 15%
0 -50000 -50000
1 24000 20869.57 24000/1/15
2 22000 16635.16
3 19500 12821.36
4 14600 8347.63
NPV 8673.72
With NPV criterion, Project A is accepted because it has higher positive NPV value.
e. PROFITABILITY RATIO
PROJECT A
= 382589.95/35000
= 1.1
PROJECT B
= 58673.72/50000
= 1.17
According to Profitability Index Decision Rule, Project B I accepted because it PI is higher than
Project A
f. According to the above analysis that I did from a-e, Payback period, Discounted
Payback, IRR (not done) and Profitability rules accept Project B while only NPV rule
accept Project A.
Therefore, the firm should accept project because it does not have ranking problem
involved in Capital Budgeting Techniques.
NPV Valuation [LO1]
25. The Yurdone Corporation wants to set up a private cemetery business. According to the
CFO, Barry M. Deep, business is “looking up.” As a result, the cemetery project will provide a
net cash inflow ow of $97,000 for the firm during the first year, and the cash flows are projected
to grow at a rate of 4 percent per year forever. The project requires an initial investment of
$1,500,000.
a. If Yurdone requires an 11 percent return on such undertakings, should the cemetery business
be started?
Initial Investment = 1500000
Cash flow for year 1 = 97000
Grow at the rate of 4% forever
Discount rate = 11%
Here, we need to use the formula of perpetual annuity growth because the cash flows are
growing for infinite period of time.
Present value of cash = cash flow at the end of year (CF1) / (required rate of return (r) – growth
rate (g)
= 97000 / (11 - 4)
= 13857.14 x 100
NPV = PV-I
= 1385714 – 1500000
= - 114286.00
Since the above business has a negative present value, it should not be started.
b. The company is somewhat unsure about the assumption of a 4 percent growth rate in its cash
flows. At what constant growth rate would the company just break even if it still required an 11
percent return on investment?

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CORPORATE FINANCE

Faisel Mohamed Pallikkattil

c. Using NPV criterion

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