FINC2011 Tutorial 6

FINC2011 Tutorial 6 - FINC2011 Tutorial 6 BMA Chapter 5...

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FINC2011 Tutorial 6 BMA Chapter 5 Problems: 1, 7, 8, 9, 10, 11, 12, 15 1. Payback a.What is the payback period on each of the following projects? b.Given that you wish to use the payback rule with a cutoff period of two years, which projects would you accept? c.If you use a cutoff period of three years, which projects would you accept? d.If the opportunity cost of capital is 10%, which projects have positive NPVs? e. “If a firm uses a single cutoff period for all projects, it is likely to accept too many short-lived projects.” True or false? f. If the firm uses the discounted-payback rule, will it accept any negative-NPV projects? Will it turn down positive-NPV projects? Explain. Answer a. A = 3 years, B = 2 years, C = 3 years. b. B c. A, B, and C d. B and C (NPV B = \$3,378; NPV C = \$2,405) e. True. The payback rule ignores all cash flows after the cutoff date, meaning that future years’ cash inflows are not considered. In addition, the payback rule ignores the timing of cash inflows. For example, for a payback rule set at two years, a project with a payback period of one year is given equal weight as a project with a payback period of two years. f. It will accept no negative-NPV projects, but will turn down some with positive NPVs. A project can have positive NPV if all future cash flows are considered but still do not meet the stated cutoff period.

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7. Capital rationing Suppose you have the following investment opportunities, but only \$90,000 available for investment. Which projects should you take? Answer The profitability index for each project is shown below: Project NPV Investment Profitability Index (NPV/Investment) 1 5,000 10,000 5,000/10,000 = 0.5 2 5,000 5,000 5,000/5,000 = 1 3 10,000 90,000 10,000/90,000 = 0.11 4 15,000 60,000 15,000/60,000 = 0.25 5 15,000 75,000 15,000/75,000 = 0.2 6 3,000 15,000 3,000/15,000 = 0.2 Start with the project with the highest profitability index and go from there. Project 2 has the highest profitability index and has an initial investment of \$5,000. The next highest profitability index is for Project 1, which has an initial investment of \$10,000.
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• Three '15

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