Question

Question 2 (25 marks/Investment Decision Rules and Project Cash Flows)

Consider a hypothetical economy that has NO tax.

ABC Ltd. is considering investing in a 2-year project which is expected to generate the following year-end cash flows: C1 = $110 million, C2 = $115 million. The yearly discount rate for the project is 10%. The initial cost of the project is $200 million.

(d) Write down the numerical formula for computing the IRR of this project. What is the minimum IRR value that would make this project acceptable? Explain.

(e) Given the recommendations based on the four decision rules above, which project should ABC Ltd. accept?

(f) Now suppose that of the $200m initial expenditure, $50m was used for the purchase of a machine that has an estimated economic life of four years. The machine will be fully depreciated (i.e., zero book value at the end of the machine’s economic life) on a straight-line basis and expected to have a resale value of $35m at the end of the project.

(i) Explain how this will affect the size of the terminal (end-of-project) cash flows.

(ii) How will this affect the NPV and the acceptance/rejection of the project (as compared to part (a))? Show your calculations.

Answer 1

1.
Profit=110+115-200=25 million

NPV=-200+110/1.10+115/1.10^2=-4.958677686 million

2.
No as NPV is negative the project should not be accepted

3.
PI=1-4.958677686/200=0.975206612

Payback=1+(200-110)/115=1.782608696 years

According to payback, accept as it is less than cutoff of 2 years'

According to PI, dont accept as it is less than 1

4.
-200+110/(1+r)+115/(1+r)^2=0
Let 1/(1+r) be x
-200+110x+115x^2=0
=>x=-1.8811,0.92454
=>x=0.92454
=>1/(1+r)=0.92454
=>r=8.161%

5.
Dont accept the project

Apologies but I am forbidden to answer more than 4 question