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# week06_TutorialAnswers - SCHOOL OF BANKING AND FINANCE...

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FINS 1613 Tutorial Answers 1 SCHOOL OF BANKING AND FINANCE FINS1613 BUSINESS FINANCE Semester 2 2010 TUTORIAL ANSWERS WEEK 6 –Capital Budgeting Applications I Please note that some answers are exact when rounded to 2 or 3 decimal places because of the use of PV tables rather than calculators. Multiple-choice Questions 1. Project A and Project B are mutually exclusive projects with equal risk. Project A has an internal rate of return of 12%, while Project B has an internal rate of return of 15%. The two projects have the same net present value when the discount rate 7%. (In other words, the "crossover rate" is 7%.) Assume each project has an initial cash outflow followed by a series of inflows. Which of the following statements is most correct? a. If the discount rate is 10%, each project will have a positive NPV. b. If the discount rate is 6%, Project B has a higher NPV than Project A. c. If the discount rate is 13%, Project B has a higher NPV than Project A. d. Statements a and b are correct. e. Statements a and c are correct. Answer is e. NPV vs IRR –theory 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% Project A Project B Since both projects have an IRR greater than the 10% discount rate, both will have a positive NPV. Therefore, statement a is true. At 6%, the cost of capital is less than the crossover rate and Project

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FINS 1613 Tutorial Answers 2 A has a higher NPV than B. Therefore, statement b is false. If the cost of capital is 13%, then the cost of capital is greater than the crossover rate and B would have a higher NPV than A (NPV of A is negative at 13%). Therefore, statement c is true. Since statements a and c are both true, the correct choice is statement e. 2. Your company is choosing between the following non-repeatable, equally risky, mutually exclusive projects with the cash flows shown below. Your cost of capital is 10%. How much value will your company sacrifice if it selects the project with the higher IRR? Project 0 1 2 3 4 5 A -1,000 500 500 500 B -2,000 668.76 668.76 668.76 668.76 668.76 a. \$243.43 b. \$291.69 c. \$332.50 d. \$481.15 e. \$535.13 Answer is b. NPV vs IRR – mutually exclusive projects calculation IRR of project A: = = × + = + = n t R t A A A PVIFA R C NPV 0 3 , 0 500 1000 ) 1 ( So, 2 500 1000 3 , = = A R PVIFA (23.88%) 24% to 20% = A R At 10% discount rate 45 . 243 4869 . 2 500 1000 500 1000 ) 1 ( 0 3 %, 10 = × + = = × + = + = = n t t A PVIFA r C NPV IRR of project B: = = × + = + = n t R t B B B PVIFA R C NPV 0 5 , 0 76 . 668 2000 ) 1 ( So, 9906 . 2 76 . 668 2000 5 , = = B R PVIFA 20% = B R At 10% discount rate 14 . 535 7908 . 3 76 . 668 2000 76 . 668 2000 ) 1 ( 0 5 %, 10 = × + = = × + = + = = n t t B PVIFA r C NPV 69 . 291 14 . 535 35 . 243 = = B A NPV NPV IRR of project A > IRR of project B, NPV project A is \$291.69 less than NPV project B
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week06_TutorialAnswers - SCHOOL OF BANKING AND FINANCE...

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