Practice Problem Set I

by Kyung Hwan Shim

University of New South Wales
Australian School of Business
School of Banking & Finance
for FINS 1613 S1 2011
May 22, 2011

These notes are preliminary and under development. They are made available for FINS 1613 S1 2011 students
only and may not be distributed or used without the authors written consent.

Question 1
The True North Resource Company is considering a project that has the same risk as True Norths
overall operations. True Norths capital structure consists of debt, preferred shares, and common
equity.
True Norths long-term debt has a face value of $1.25 million and an annual coupon rate of 15
percent. The bonds have 13 years remaining until maturity (a coupon payment was just made)
and are currently priced in the market to yield 7.4 percent.
True North has 5,700 preferred shares outstanding. The preferred shares each sell for $87.75 and
pay a 7.9 percent dividend rate on a par value of $100.
The total book value of True Norths common equity is $2.2 million; book value per share is $55.
The stock sells for a price of $62.50 per share. The companys financial manager estimates that the
beta of True Norths common equity is 1.182. She has also determined that the current Treasury
bill rate is 4.5 percent and that the expected rate of return on the market is 10 percent.
True Norths corporate tax rate is 44 percent.
a. Calculate the market values and before tax required returns for True Norths debt, its preferred
equity and its common equity.
b. Since True North is evaluating a new investment project that has the same market risk as the
True Norths overall operations, calculate the rate True North should use to discount the projects
cash flows.
c. The True North Resource Company is considering a project that will generate perpetual before
tax cash flows of $150,000 per year beginning next year. The project has the same risk as the
firms overall operations. What is the most that True North can pay for the project and still earn
its required return?

Question 2
Consider 2 mutually exclusive investment projects, A and B. The cashflows and IRRs are as
follows:
Project

t=0

t=1

t=2

IRR

-4,000

2,410

2,930

21%

-2,000

1,310

1,720

31%

A-B

-2,000

1,110

1,210

10%

The firms opportunity cost of capital is 9%. On the basis of the IRR rule, which project should
you accept if you can only undertake one project? Provide supporting explanations.
Question 3
Consider 2 mutually exclusive investment projects, C and D. The cashflows and IRRs are as
follows:
Project

t=0

t=1

t=2

t=3

NPV

IRR

-400

220

310

37.5

19.7%

-400

130

190

260

44.0

18.7%

C-D

90

120

-260

16.4%

D-C

-90

120

260

16.4%

The firms opportunity cost of capital is 13%.

(a) We observe that the NPV of project D is greater than the NPV of project C. Verify that
project D does add value beyond project C by computing the NPV for the incremental cashflows
in D, beyond C. Provide all calculations and discuss.
(b) Suppose, instead, that you had focused on the incremental cashflows in C beyond D (i.e.
C-D). Discuss how N P VCD and IRRCD can be relied upon to reach the conclusion that D
adds value beyond C, i.e., that project D is better than project C.

Question 4
You are given the following information about the NPV of two mutually exclusive investment
projects E and F of similar size and duration:
N P V (E) > 0, N P V (F ) > 0, N P V (E F ) < 0
Which project, if any, should you accept? Explain and illustrate your answer in a NPV diagram.

Question 5
A recent study of corporate decision making in Australia has shown that many firms rely on the
IRR to assess projects.
Your superior has asked you to evaluate two mutually exclusive projects using the internal rate
of return criterion. The firms opportunity cost of capital is 10%. The after-tax cashflows from
the two projects are as follows:

Project

t=0

t=1

t=2

t=3

-400

496

-400

200

200

163

(a) Which project has the higher IRR? You dont have to compute the IRR value precisely; rather,
you should try a few values between 16% and 25% for each project, plot those points, and make
a rough estimate of IRR.
(b) Your superior goes on to ask for your opinion on the wisdom of using the IRR rather than
the NPV in this particular case. Discuss the issue, using projects A and B as illustrations.

Question 6
Levered Ltd. and Unlevered Ltd. are identical companies, except for capital structure. They
operate in a perfect capital market with no taxes, transactions costs, or bankruptcy costs. The
two companies have identical assets and identical business risk. Each company is expected to
produce net cashflows of $96 million per year in perpetuity, and each company distributes all its
cashflows. Levereds debt has a market value of $275 million and provides a return of 8 percent.
Levereds stock sells for $100 per share and there are 4.5 million outstanding shares. Unlevered
has only 10 million outstanding shares worth $80 each. Unlevered has no debt.
(a) What are the market values of the two firms?
(b) Which stock is a better investment and why?
(c) Why would the firm values in (a) be inconsistent with Modigliani and Millers Proposition I?
(d) Modigliani and Miller would claim that the valuation of the two firms in (a) could not persist.
Describe in words the mechanism that would bring about the necessary adjustment in the firm
values and how it works.
(e) An investor who is able to borrow or lend at 8 percent owns 125 shares of Unlevered stock.
Show how this investor can take advantage of the firm values in (a) to earn an arbitrage profit
today. Describe in detail the actions that the investor would take. Calculate the cash flows today
from following the strategy, as well as the cash flows in future periods. Show that the investors
strategy would generate an arbitrage profit today.