Project Appraisal

Final Test
Special Date

September 9, 2022

School Year 2021-22 Exam’s Solution Topics

PART I
1. The CFO of Blue Monkey, a clothing manufacturer, informs you that the
company dividend yield is 5%, the expected dividends’ growth rate is 5%,
their current rating implies a default spread of 250 bps over the 2.5% risk-
free rate, and the tax rate is 40%. The current financial policy of the
company does not allow for additional external equity financing and
prevents further financial leverage. A proforma income statement and
balance sheet are presented below.

PROFORMA INCOME STATEMENT PROFORMA BALANCE SHEET

(1) Sales 300.0 ASSETS % Sales

(2) Costs 225.0 (1) Net Current Assets 1000
(3)=(1)-(2) Taxable Income 75.0 (2) Net Fixed Assets 1000
(4) Taxes (40%) 30.0 (3)=(1)+(2) Total Assets 2000 667%
(5)=(3)-(4) Net Income 45.0 LIABILITIES & EQUITY % Assets
(6) Dividends 30.0 (4) Debt 1500 75%
(7) Retained Earnings 15.0 (5) Owner's Equity 500 25%
(6)=(4)+(5) Liabilities & Equity 2000

a. Use the dividend growth model to estimate Blue Monkey’s cost of

equity. [1.5 pts]
b. Compute the firm’s WACC. [1.5 pts]

(1)=(2)*(1+(3))+(3) Dividend Growth Model CoE 10.25%

(2) Dividend Yield t=0 5%
(3) Dividend Growth 5.0%

(4)=((5)+(6))*(1-(7)) CoD 3%
(5) Risk-free rate 2.50%
(6) Default Spread 2.50%
(7) Tax Rate 40%

(8)=0.25*(1)+0.75*(4) WACC 4.8125%

1
 2. Blue Monkey is considering an investment in Mozambique. Three potential
locations have been studied involving different investment, wage, and
transportation costs. The CFO is concerned with the political and social
stability of the country and requires the dynamic payback period to be no
longer than 3 years. Which project do you recommend Blue Monkey to
undertake? Please justify your advice. [2 pts]

Million €
IO PV CF1 PV CF2 PV CF3 PV CF4 NPV
Nampula -100 50 50 5 5 10
Beira -50 20 20 20 20 30
Xai-Xai -75 25 25 25 25 25
IO = Initial Outlay
PV CFj = Present Value of Cash Flow year j
NPV = Net Present Value

Million € Payback Constraint Max.

IO PV CF1 PV CF2 PV CF3 PV CF4 NPV Period =< 3 NPV
Nampula -100 50 50 5 5 10 2 Complies
Beira -50 20 20 20 20 30 2.5 Complies <
Xai-Xai -75 25 25 25 25 25 3 Complies
IO = Initial Outlay
PV CFj = Present Value of Cash Flow year j
NPV = Net Present Value

PART II

3. Red Banana, a Blue Monkey close competitor, has devised a plan to free
working capital by redesigning the production and logistic processes and
redefining the terms and conditions applied to both clients and providers.
The 350,000 euros investment costs are not tax-allowed to be
depreciated. The recovery of working capital investment is estimated to be
750,000 euros at the end of the first year. The implemented changes are
expected to have an incremental after-tax cost of 5,000 euros in the first
year and to grow annually at 3% forever.
a. Knowing that Red Banana’s WACC is 5%, do you think their project
adds to the firm’s wealth? Justify your answer. [1.5 pts]

2
 PV
Investment -350
Working Capital Release 750 714.3
Incremental OCF t=1 -5 -250.0
OCF growth rate 3%
WACC 5%
NPV 114.29

b. Red Banana’s financial policy is even stricter than Blue Monkey’s

since no external financing is admissible. Knowing that Asset
Needs = 12.65 x Sales Growth Rate (in %) and Retained Earnings
= 25 + 0.15 x Sales Growth Rate (in %), what is Red Banana’s
maximum sales growth rate? [1.5 pts]

Asset Needs = Retained Earnings 

12.65 x Sales Growth Rate = 25 + 0.15 x Sales Growth Rate

Max. Sales Growth Rate = 2%

4. Lightning Power Company needs to invest in a new power generating

facility and must decide between two options: a windfarm with an
estimated NPV of 99 million euros over its 20 years economic life; and a
solar-power plant with a projected NPV of 105 million euros over an
economic life of 25 years.
a. Assume a hurdle rate of 8% and advise Lightning on their two
investment options. Please justify your advice. [1.5 pts]

Ec Life NPV r NPV n Divisor NPV p

Wind-farm 20 99 0.2732 126.0
Solar-power plant 25 105 0.1710 123.0
Cost of Capital 8%

b. Lightning derives 60% of its revenues from Portugal, 20% from

Poland, and 20% from Canada. The equity risk premium in each of
those 3 markets is respectively 6.5%, 7%, and 5.5%. Lightning beta
is 0.95 and the risk-free rate is 2.5%. Determine Lightning’s equity
risk premium and cost-of-equity. [1.5 pts]

3
 ERP % Revenues
Portugal 6.50% 0.6
Poland 7.00% 0.2
Canada 5.50% 0.2

(1) Total ERP 6.4%

(2) Beta 0.95
(3) Risk-free 2.50%
(3)+(2)*(1) CoE 8.58%

c. The CFO is intrigued by the notion of implied risk premium. Please

explain the concept and how it could be computed. [1 pts]

The implied equity risk premium is one of the three possible ways of
estimating the equity market risk premium along average investor survey
premiums and historical premiums.
The implied equity risk premium is extracted from the current stock index
value, expected cash to stockholders (dividends and buy-backs) and its
expected growth rate by computing the implied rate of return and
subtracting the risk-free rate.

PART III
5. The F-300 filtering system of a water treatment plant is approaching the
end if its economic life and maintenance costs are increasing. The
company operating the plant is considering its replacement by a new F-
550 filtering system. The F-300 was bought for 10 million euros 8 years
ago. Its tax-allowed economic life is 10 years. The straight-line
depreciation method is used. Its sale value is currently estimated at 4
million, but in 10 years’ time it will be worthless. The new F-550 model cost
is 15 million euros, has an economic life of 10 years and is to be
depreciated on a straight-line. The estimated sale value in 10 years’ time
is 5 million euros. The new model has more capacity allowing treatment of
a larger volume of water. This will bring in an additional 2 million euros in
yearly revenues. Its operating and maintenance costs are 0.1 million euros
per year which compares favourably with 0.6 million euros of identical
expenses with the old model. The acquisition of the new model will benefit
from a tax-exempt government grant of 0.4 million euros in the 1st and 2nd
years. The company tax rate is 40%, and the discount rate is 10%.
a. Determine the initial after-tax capital cash flow. [1.5 pts]
b. Determine the terminal after-tax capital cash flow. [1.5 pts]
c. Determine the incremental after-tax operating cash flows. [1.5 pts]
d. Compute the project’s NPV and present your advice regarding the
replacement of the filtering system. [1.5 pts]

4
 0 1 2 3 4 5 6 7 8 9 10
Initial Investment -15
Sale F-300 4
Tax on Sale -0.8
OCF
1 O&M Costs F-300 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6
2 O&M Costs new F-550 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1
3 Inc Revenue new F-550 2 2 2 2 2 2 2 2 2 2
4=(1-2+3)*0.6 Incremental after tax 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5
5 Depreciation F-550 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5
6=5*0.4 Tax Shield 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6
7 Depreciation F-300 1.0 1.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
8=7*0.4 Tax Shield 0.4 0.4 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
9=6-8 Incremental Tax Shield 0.2 0.2 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6
10 Government Aid 0.4 0.4
11=4+9+10 OCF incremental CF 2.1 2.1 2.1 2.1 2.1 2.1 2.1 2.1 2.1 2.1

0 1 2 3 4 5 6 7 8 9 10
Teminal Flows
Sale F-550 5
Tax -2.0
Sale F-300 0
Tax 0
Terminal CF 3
Incremental CF -11.8 2.1 2.1 2.1 2.1 2.1 2.1 2.1 2.1 2.1 5.1

NPV 2.26

PV Factor
Initial -11.8
OCF 12.9 6.145
Term. Value 1.2
Total 2.26

PART IV
6. Red Robin, a retailer, has seen its premisses destroyed by war ravaging
one of its international locations. It must decide whether to rebuild or
abandon its operations in that country. An international consultant has
presented a decision tree where required decisions are marked with
square and event nodes have a probability beneath them. The associated
NPV is stated at the end of each branch. Your task is to present a decision
proposal justifying your advice regarding the two decisions. [2 pts]

5
 NODES
1 2 3 4 5
NPV

High Sales 150

Own Brand 40%
Low Sales 50
War Ends 60%
80%
High Sales 70
Rebuild Franchise 40%
Low Sales 20
60%
War Continues -60
20%

Abandon -10

Two decison nodes: 3 (stay with own brand/franchise) and 2 (Rebuild/Abandon)

Node 3
Exp Value
Own Brand 90
Franchise 40

Decision Own Brand

Exp Value
Node 2 Rebuild 60
Abandon -10

Decision Rebuild