Question

Question 3

Consider two projects, A and B, associated with the following expected cash flow sequences

Year	Project A	Project B
0	-950	-950
1	400	240
2	400	240
3	450	240
4	0	240
5	0	240
6	0	240

You are acting as the Chief Financial Officer of a firm. Suppose you face a capital rationing constraint such that you have a limit of 950 currency units in your budget. Your firm’s weighted average cost of capital (WACC) is 8%, and you assume that the cost of capital for each project A and B is also 8%. Address the following questions

1. Calculate the Internal Rates of Return of the projects, A and B. [20 marks]

2. Calculate the Net Present Values and Profitability Indices of the projects, A and B.  [20 marks]

3. Which project would you recommend by way of an investment for your corporation? Why? [40 marks]

4. Is it reasonable to assume that both projects have the same WACC? [20 marks]

Question 4

1. Do financial derivative instruments have a role to play in corporate finance? If so, what is this role? [40 marks]

2. The put-call parity relation can be stated:

Call + PV (Exercise Price) = Put + Security Price

Can we have confidence that this relation is satisfied in any given capital market? How might knowledge of such a relation be useful to a Chief Financial Officer? [60 marks]

Answer 1

1.
IRR of A:
-950+400/(1+IRR)+400/(1+IRR)^2+450/(1+IRR)^3=0
=>IRR=14.76%

IRR of B:
-950+240/(1+IRR)+240/(1+IRR)^2+240/(1+IRR)^3+240/(1+IRR)^4+240/(1+IRR)^5+240/(1+IRR)^6=0
=>IRR=13.36%

2.
NPV of A:
=-950+400/(1+8%)+400/(1+8%)^2+450/(1+8%)^3
=120.5304

NPV of B:
=-950+240/(1+8%)+240/(1+8%)^2+240/(1+8%)^3+240/(1+8%)^4+240/(1+8%)^5+240/(1+8%)^6
=$159.49

PI of A:
=1+120.5304/950=1.12687410526316

PI of B:
=1+159.49/950=1.16788421052632

3.
Annual NPV of A:
=120.5304*8%/(1-1/1.08^3)=46.7698346614095

Annual NPV of B:
=159.49*8%/(1-1/1.08^3)=61.8874651552489

Recommend Project B

4.
No Project A should have higher return as it has higher risk and Project B has stable cash flows