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Tutorial 6: Valuation – Investments (tutorial in week 7)

1. Explain why the cost of capital is referred to as the ‘hurdle’ rate in capital budgeting.

Answers:
The cost of capital is the minimum required return on any new investment that allows
a company to break even. Since we are using the cost of capital as a benchmark or
“hurdle” to compare the return earned by any project, it is sometimes referred to as
the hurdle rate.

2. What are the differences between capital projects that are independent, mutually
exclusive and contingent?

Answers:
A project is independent if the decision to accept or reject it does not affect the decision
to accept or reject another project. On the other hand, projects are mutually exclusive
if the acceptance of one implies rejection of the other. Contingent projects are those in
which the acceptance of one project is dependent on another project.

3. In the context of capital budgeting, what is ‘capital rationing’?

Answers:
Capital rationing implies that a company does not have the resources necessary to fund
all of the available projects. In other words, funding needs exceed funding resources.
Thus, the available capital will be allocated to the projects that will benefit the company
and its shareholders the most. Projects that create the largest increase in shareholder
wealth will be accepted until all the available resources have been allocated.

4. A company takes on a marketing project that would earn a return of 12 per cent. If
the appropriate cost of capital is also 12 per cent, did the company make the right
decision? Explain.

Answers:
We would normally argue that a company should only accept projects in which the
project’s return exceeds the cost of capital. In other words, only if the net present
value exceeds zero should a project be accepted. But in reality, projects with a zero
NPV should also be accepted because the project earns a return that equals the cost
of capital. For some companies like the one above, this could be the situation because
they may not have projects that provide a return greater than the cost of capital for
the company.

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5. What is the impact on the company if it accepts a project with a negative NPV?

Answers:
When a company takes on positive NPV projects, the value of the company
increases. By the same token, when a project undertaken has a negative NPV, the
value of the company will decrease by the amount of the net present value.

6. Identify the weaknesses of the payback period method.

Answers:
There are several critical weaknesses in the payback period approach of evaluating
capital projects.

 The payback period ignores the time value of money by not discounting future
cash flows.
 When comparing projects, it ignores risk differences between the projects.
 A company may establish payback criteria with no economic basis for that
decision and thereby run the risk of losing out on good projects.
 The method ignores cash flows beyond the payback period, thus leading to
nonselection of projects that may produce cash flows well beyond the payback
period or more cash flows than accepted projects. This leads to a bias against
longer-term projects.

7. Franklin Mints, a confectioner, is thinking of purchasing a new jellybean-making


machine at a cost of $312 500. The company projects that the cash flows from this
investment will be $121 450 for the next 7 years. If the appropriate discount rate is
14 per cent, what is the NPV for the project?

Answers:
Initial investment = $312,500
Annual cash flows = $121,450
Length of project = n = 7 years
Required rate of return = k = 14%
n NCF
NPV   t

t  0 (1  k )
t

$121,450 $121,450 $121,450 $121,450 $121,450


 $312,500     
(1.14)1 (1.14) 2 (1.14)3 (1.14) 4 (1.14)5
$121,450 $121,450
 
(1.14)6 (1.14)7
 $312,500  $106,535  $93,452  $81,975  $71,908  $63,077  $55,331  $48,536
 $208,315

8. Quant Ltd is purchasing machinery at a cost of $3 768 966. The company expects, as


a result, cash flows of $979 225, $1 158 886 and $1 881 497 over the next 3 years.
What is the payback period?

2
Answers:
Cumulative
Year CF Cash Flow
0 $(3,768,966) $(3,768,966)
1 979,225 (2,789,741)
2 1,158,886 (1,630,855)
3 1,881,497 250,642

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($1,630,855 / $1,881,497) = 2.87 years

9. Champlain Ltd is investigating two computer systems. The Alpha 8300 costs
$3 122 300 and will generate annual cost savings of $1 345 500 over the next 5
years. The Beta 2100 system costs $3 750 000 and will produce cost savings of
$1 125 000 in the first 3 years and then $2 million for the next 2 years. If the
company’s discount rate for similar projects is 14 per cent, what is the NPV for the
two systems? Which one should be chosen based on the NPV?

Answers:
Cost of Alpha 8300 = $3,122,300
Annual cost savings = $1,345,500
Length of project = n = 5 years
Required rate of return = k = 14%
 1 
 1
n FCFt (1.14)5 
NPV    $3,122,300  $1,345,500   
t  0 (1  k )
t
 0.14 
 
 $3,122,300  $4,619,210
 $1,496,910

Cost of Beta 2100 = $3,750,000


Length of project = n = 5 years
Required rate of return = k = 14%
 1 
 1
n
FCFt (1.14)3  $2,000,000 $2,000,000
NPV    $3,750,000  $1,125,000    
t  0 (1  k )
t
 0.14  (1.14) 4 (1.14)5
 
 $3,750,000  $2,611,836  $1,184,161  1,038,737
 $1,084,734
Based on the NPV, the Alpha 8300 system should be chosen.