Advanced Corporate Finance Leonidas Rompolis

EXERCISES -1 (SOLUTIONS)

1. NPV = −$1,300,000 + ($1,500,000/1.10) = +$63,636

Since the NPV is positive, you would construct the motel.

2. a. Expected cash flow (Project B) = ($4 million + $6 million + $8 million)/3

Expected cash flow (Project B) = $6 million
Expected cash flow (Project C) = ($5 million + $5.5 million + $6 million)/3
Expected cash flow (Project C) = $5.5 million
b. Expected rate of return (Stock X) = ($110/$95.65) –1 = 0.15 = 15.0%
Expected rate of return (Stock Y) = ($44/$40) –1 = 0.10 = 10.0%
Expected rate of return (Stock Z) = ($12/$10) –1 = 0.20 = 20.0%
c.
Percentage Differences
Slump v. Normal Boom v. Normal
Project B 4/6 = 66.67% 8/6 = 133.33%
Project C 5/5.5 = 90.91% 6/5.5 = 109.09%
Stock X 80/110 = 72.73% 140/110 = 127.27%
Stock Y 40/44 = 90.91% 48/44 = 109.09%
Stock Z 8/12 = 66.67% 16/12 = 133.33%

Project B has the same risk as Stock Z, so the cost of capital for Project B is 20%.
Project C has the same risk as Stock Y, so the cost of capital for Project C is 10%.
d. NPV (Project B) = −$5,000,000 + ($6,000,000/1.20) = 0
NPV (Project C) = −$5,000,000 + ($5,500,000/1.10) = 0
e. The two projects will add nothing to the total market value of the company’s
shares.

2.3 2.6 2.8 3.0 3.1 2.9

3. NPV = −12 + + + + + + = 1.57 , and the project
1.06 1.06 1.06 1.06 1.06 1.066
2 3 4 5

should be accepted.

⎡1 1 ⎤
4. PV = C ⎢ − t ⎥
⇒ 500, 000 = C × 9.7122 ⇒ C = 51, 481
⎣ r r(1 + r) ⎦
C 51, 481
PV = = = 858, 023
r 0.06

C 2, 000, 000
5. a. PV = = = 14, 285, 714
r + g 0.1 + 0.04

1
Advanced Corporate Finance Leonidas Rompolis

⎡ 1 1 (1 − 0.04) 20 ⎤
b. PV = 2, 000, 000 ⎢ − 20 ⎥
= 13,347,131
⎣ 0.1 + 0.04 0.1 + 0.04 (1 + 0.1) ⎦

6. After one year:

FVA = $1,000 × (1 + 0.12)1 = $1,120
FVB = $1,000 × (1 + 0.0585)2 = $1,120.4
FVC = $1,000 × e(0.115 × 1) = $1,121.9
After five years:
FVA = $1,000 × (1 + 0.12)5 = $1,762.3
FVB = $1,000× (1 + 0.0585)10= $1,765.7
FVC = $1,000 × e(0.115 × 5) = $1,777.1
After twenty years:
FVA = $1,000 × (1 + 0.12)20 = $9,646.3
FVB = $1,000 × (1 + 0.0585)40= $9,719.3
FVC = $1,000 × e(0.115 × 20) = $9,974.2
The preferred investment is C.

7. a. NPVA = 39.06, IRRA = 19.71% and NPVB = 54.96, IRRB = 15.97%. The better
investment is B.
b. NPVA = 5.38, IRRA = 19.71% and NPVB = -13.74, IRRB = 15.97%. The better
investment is A.

8.

1000

500

0
-0.40 -0.20 0.00 0.20 0.40 0.60
NPV

-500 NPV

-1000

-1500

-2000
Discount rates

The IRR are -17.5% and 45.5%. If the OCC lies between these two values the NPV is
positive