Problem Set

Problem set 1: Chapter 8 – 6, 7, 9, 20, 25, 27, 30, 32

6. Plan:

a. Draw a timeline to show when the cash flows will occur.

b. Determine the NPV of the cash flows at 6% interest and 2% interest.

Execute:

0 | 1 | 2 | 3 | | | | 10 |

| | | | | | | | | | | | |

| | | | | | | | | | | | |

–10,000 | 500 | 1,500 | | | | | 10,000 |

a.

b.

Evaluate:

a. Because at a 6% interest rate, the NPV is –$2,609.36, which is less than zero, you would not take this investment opportunity.

b. Because at a 2% interest rate, the NPV is $135.43, which is greater than zero, you would take this investment opportunity.

7. Plan: Draw the timeline of the cash flows for the investment opportunity. Compute the NPV of the investment opportunity at 2% interest per year to determine if it is an attractive investment opportunity.

0 | 1 | 2 | 3 |

| | | | | | | |

| | | | | | | |

–1,000 | 4,000 | –1,000 | 4,000 |

Execute:

Evaluate: Because the investment opportunity has a positive NPV of $5,729.69, Marian should make the investment.

9. Plan: We can compute the NPV of the project using an approach similar to Eq. 8.3. The cash flows are an immediate $100 million outflow followed by a perpetuity inflow of $30 million

per year, starting in year 2, and a discount rate of 8%. We can compute the IRR using a financial calculator or spreadsheet or by setting the NPV equal to zero and solving for r. After we find the

IRR, we can compute the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged by subtracting the cost of capital from the IRR.

Execute:

Timeline:

0 | 1 | 2 | 3 | 4 |

| | | | | | | | | |

| | | | | | | | | |

–100 | | 30 | 30 | 30 |

The IRR solves

So, the cost of capital can be underestimated by 16.16% without changing the decision.

Evaluate: The NPV rule...