PRACTICE ON INVESTMENT DECISIONS

QUESTIONS

1) The cash flows associated with three different projects are as follows:

Alpha Beta Gamma

($ in millions) ($ in ($ in millions)
Cash Flows millions)
Initial Outflow - 1.5 - 0.4 - 7.5
Year 1 0.3 0.1 2.0
Year 2 0.5 0.2 3.0
Year 3 0.5 0.2 2.0
Year 4 0.4 0.1 1.5
Year 5 0.3 - 0.2 5.5

a. Calculate the payback period of each investment.

b. Which investments does the firm accept if the cutoff payback period is three
years? Four years?
c. If the firm invests by choosing projects with the shortest payback period,
which project would it invest in?

2) Scotty Manufacturing is considering the replacement of one of its machine tools.

Three alternative replacement tools—A, B, and C—are under consideration. The
cash flows associated with each are shown in the following table. The firm’s
cost of capital is 15 percent.

A B C
Initial cash
outflow (CFo) $95,000 $50,000 $150,000
Year (t) Cash Inflows (CFt)
1 $20,000 $10,000 $58,000
2 20,000 12,000 35,000
3 20,000 13,000 23,000
4 20,000 15,000 23,000
5 20,000 17,000 23,000
6 20,000 21,000 35,000
7 20,000 - 46,000
8 20,000 - 58,000

a. Calculate the NPV of each alternative.

b. Using NPV, evaluate the acceptability of each tool.
c. Rank the tools from best to worst, using NPV.

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3) Michael’s Bakery is evaluating a new electronic oven. The oven requires an initial
cash outlay of $19,000 and will generate after-tax cash inflows of $4,000 per
year for five years. For each of the costs of capital listed, (1) calculate the NPV,
(2) indicate whether to accept or reject the machine, and (3) explain your
decision.
a. The cost of capital is 10 percent
b. The cost of capital is 12 percent.
c. The cost of capital is 14 percent.

4) Consider a project with the following cash flows and a firm with a 15 percent cost
of capital.

End of Year Cash Flow

0 −$40,000
1 50,000
2 −10,000

a. What are the two IRRs associated with this cash flow stream?
b. If the firm’s cost of capital falls between the two IRR values calculated in
part (a), should it accept or reject the project?

5) Sharpe Manufacturing is attempting to select the best of three mutually exclusive

projects. The initial cash outflow and after-tax cash inflows associated with each project
are shown in the following table.

Cash Flows Project X Project Y Project Z

Initial cash outflow (CFo) $80,000 $130,000 $145,000
Cash inflows (CFt), years (t) =1-5 27,000 41,000 43,000

a. Calculate the payback period for each project.

b. Calculate the NPV of each project, assuming that the firm has a cost of
capital that is equal to 13 percent.
c. Summarize the preferences dictated by each measure, and indicate which
project you would recommend. Explain why.

6) Butler Products has prepared the following estimates for an investment it is

considering. The initial cash outflow is $20,000, and the project is expected to
yield cash inflows of $4,400 per year for seven years. The firm has a 10 percent
cost of capital.
a. Determine the NPV for the project.
b. Determine the PP for the project.
c. Would you recommend that the firm accept or reject the project? Explain
your answer.

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07) Your company is deciding to invest in one of the two different projects below:

Project Initial Cash Flow (million €)

Investment Year 1 Year 2 Year 3
(million €)
A 350 350 350 350
B 200 100 200 800

a) If you know that the interest rate is 9%, use the NPV to choose the best project
to invest.
b) If you use the PP, would your decision be the same? Explain.

8) A decision maker has information about two different projects. S/he also knows that
the interest rate is 9%.

Project Initial Cash Flow

Investment Year 1 Year 2 Year 3 Year 4
A 600.000 -100.000 450.000 200.000 X
B 400.000 300.000 100.000 100.000 50.000

A) What is the minimum value for X that makes project A more interesting than project
B, if we compare the projects using the NPV?

B) If the decision maker increases the initial investment in project B by 25%, the cash
flow for years 1 and 2 should also increase by 25%. The cash flow in years 3 and 4
would not change. Using the NPV, is it better to increase the initial investment by 25%
or not?

9) What are the acceptable interest rates for the following project?

Year Revenues Cost

0 1500
1 3000 2500
2 4500 3500
3 5000 4500
4 3000 2000

10) If you know that the interest rate is 7% and the IRR is 10%, what is the NPV for a
project that will last 3 years and will provide a positive cash flow of 10.000 each year?
Would you invest in this project if the interest rate increased from 7 to 9%?

11) Mrs. Keller is planning to make an investment and is asking your opinion to help
her to make a decision. She tells you that she expects a 10% interest rate. She shows
you a report with two projects she has in mind.

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a) She is planning to buy a one-bedroom apartment in Chamberi to resell it. The

apartment costs 350.000 and she will have to fix the bathroom in this apartment
before selling it. It will take one year to fix it. If she buys it, she will be fixing it
in the first year and will be selling in the end of the first year for 450.000. The
cost to fix the bathroom is 60.000 euros. She asks you to calculate the internal
rate of return.

b) The second project is to buy a big house in Salamanca. If she buys the house,
she wants to sell it in the end of the third year. The house costs 400.000 and she
knows that she will be able to sell it by 25% more than the original price. Mrs.
Keller plan to rent the house during the three years and she plans to charge the
same rent each year. However, she also knows that she will have to pay 1400
each year for the heating and water bills. How much should Mrs. Keller ask for
this rent to make this option more appealing than the apartment in Chamberi?
Use the NPV to answer.