FNCE10002 Principles of Finance

Semester 2, 2024

Capital Budgeting I
Tutorial Questions for Topic 7’s Lecture

Priority Questions: A1, A2, B1, B4 and B5

Note that questions flagged as “EXM” are past exam questions that I’ve used in this subject or
subjects similar in scope to this subject, while those flagged as “TXT” are sourced from the textbook.
Note that any questions not covered in your tutorial should be viewed as study questions for the final
exam.

A. Problems and Case Study

A1.EXM You are deciding between two mutually exclusive investment opportunities. Both
require the same initial investment of $10 million. Project A will generate $2.0 million per
year (starting at the end of the first year) forever. Project B will generate $1.5 million at the
end of the first year and the cash flows will then grow at a rate of 2% per annum forever.

a) Which investment has the higher IRR?

b) Which investment has the higher NPV when the required rate of return is 7%?

c) For what values of the required rate of return does picking the higher IRR project give the
same decision as the NPV method? (Hint: Set the NPVs equal to each other and solve for
the required rate of return.)

d) Using your analysis in part (c) and the incremental IRR rule which investment would you
choose when the required rate of return is 7%? At what required rate of return would your
decision change and why?

A2.TXT The cash flows associated with three independent projects are as follows:

Net Cash Flows Project Alpha Project Beta Project Gamma

Year 0 –$1,500,000 –$400,000 –$7,500,000
Year 1 $300,000 $100,000 $2,000,000
Year 2 $500,000 $200,000 $3,000,000
Year 3 $500,000 $200,000 $2,000,000
Year 4 $400,000 $100,000 $1,500,000
Year 5 $300,000 –$200,000 $5,500,000

Suggested Answers to Tutorial Questions for Topic 7’s Lecture 1

 a) Calculate the payback period of each investment.

b) Which investments does the company accept if the cut-off payback period is three years?
What if the cut-off is four years?

c) Which one of these projects is a project that almost certainly should be rejected, but
might be accepted if the company uses the payback period method? Explain.

d) Which one of these projects almost certainly should be accepted (unless the company’s
discount rate is very high), but might be rejected if the company uses the payback period
method. Explain.

e) What is the maximum number of internal rates of return that each project can have and
why?

A3. Refer to the case study related to the market’s interpretation of NPV covered in class where
we examined Microsoft’s takeover of LinkedIn in 2016 (pages 7.12 – 7.15 of your lecture
notes). Suppose Microsoft announces that because of its inability to fully integrate LinkedIn
into its Office software/cloudware it has decided to sell its LinkedIn operations at a
significantly lower value compared to the US$26 billion it had paid in 2016. How do you
think the market would react to this decision and why? Explain.

B. Multiple Choice Questions

For each question pick the most reasonable response based only on the information provided.

B1.EXM You have analyzed an investment project which has a conventional cash flow pattern.
Assuming that the original project has a positive NPV, if the initial outlay and all the expected
net cash flows are doubled what is the most likely effect on the project’s net present value and
internal rate of return?

a) Both the IRR and NPV would increase.

b) The IRR would stay the same and the NPV would increase.
c) The IRR would increase and the NPV would stay the same.
d) Both the IRR and NPV would stay the same.

B2.EXM Which of the following items of information is least likely to be necessary for
evaluating an investment project?

a) The project’s initial cash outlay.

b) The project’s life.
c) The project’s internal rate of return.
d) The project’s required rate of return (or discount rate).

B3.EXM Which of the following statements about the payback period method of project
evaluation are most likely to be true?

I. It is very rarely used by managers in the “real” world.

II. It tends to discriminate against projects with long development periods.
III. It tends to discriminate against projects with large net cash flows later in their lives.

a) I and II only.
b) II and III only.
c) I and III only.

Suggested Answers to Tutorial Questions for Topic 7’s Lecture 2

 d) I, II and III.
Questions B4 and B5 are based on the following information.

A project has an initial outlay of $50,000 and its expected net cash flows are $12,000 per year for the
next eight years. The project is to be evaluated using a required rate of return of 12% p.a.

B4. The project’s net present value is closest to:

a) –$40,433.
b) –$9,612.
c) $9,612.
d) $40,433.

B5. The project’s internal rate of return is closest to:

a) 9.5%.
b) 11.3%.
c) 14.6%.
d) 17.3%.

C. Closing the loop with Desmos interactive graphs

This week we are going to demonstrate graphically how IRR and NPV may give conflicting answers
using Question A1 as our example.

Open the Desmos graph that sets out the relationship between NPV and IRR for Projects A and B
from question A1: https://www.desmos.com/calculator/37gjvykkpo

Answer the questions asked in A1, but this time do so only by changing the discount rate using the
slider that allows you to specify the discount rate r.

Suggested Answers to Tutorial Questions for Topic 7’s Lecture 3

 FNCE10002 Principles of Finance
Semester 2, 2022

Capital Budgeting I
Suggested Answers to Tutorial Questions for Topic 7’s Lecture

A. Problems and Case Study

A1. a) The timelines for the two projects are as follows:

0 1 2 3

Project
A –10.0m 2.0m 2.0m 2.0m

Project 1.5(1.02) 1.5(1.02)2

B –10.0m 1.5m m m

For project A we have:

Setting NPVA = 0 we can solve for IRRA as follows:

For project B, we have:

Setting NPVB = 0 we can solve for IRRB as follows:

Suggested Answers to Tutorial Questions for Topic 7’s Lecture 4

 Using the IRR method, we would accept project A.

b) Substituting r = 0.07 into the expressions for the NPV above gives us:

Using the NPV method we would accept project B.

c) The NPV rule selects project A (and so agrees with the IRR rule) for all discount rates to
the right of the point where the NPV profiles cross. The crossover point can be calculated
by setting the NPVs to be equal to each other and solving for the discount rate, as follows:

1.5r = 2.0r – 0.04.

So, r = –0.04/–0.5 = 8%.

So, the IRR rule will give the same decision as the NPV for discount rates greater than
8%.

Although the question does not ask for the NPV profiles, these are as follows.

$130

$110

$90 Project B

$70

Project A
$50

$30

$10

-$10
3% 8% 13% 18% 23% 28% 33%

Suggested Answers to Tutorial Questions for Topic 7’s Lecture 5

 d) From part (c) we know that the incremental IRR is 8%. This is because calculating the
incremental IRR requires us to subtract the cash flows of project A from project B. At a
discount rate of 8% the NPV profile of this incremental “project” B – A will cross the x
axis, that is, the NPV will be 0 at 8%. This, of course, is the definition of the IRR of a
project. As this IRR is above the required rate of return we would accept project B. (Note
that for required rates of return above the IRR of 8% we would prefer to invest in project
A, if its NPV is positive).

A2. a) The payback periods are as follows:

Project Alpha: 3 + 200000/400000 = 3.5 years.

Project Beta: 2 + 100000/200000 = 2.5 years.

Project Gamma: 3 + 500000/1500000 = 3.3 years.

b) If the cut-off is 3 years, then only Beta is acceptable. If the cut-off is 4 years, then all the
projects are acceptable.

c) Project Beta should be rejected. In aggregate terms, you are paying out a total of
$600,000 and taking in $600,000. When there is a time value to money, that is, a positive
discount rate, this would be an unacceptable project. That is, if the cash inflows and
outflows are the same, this is a negative net present value project. To confirm this we
would calculate the NPV of the project – this highlights the more general point that
although payback period is popular due to the information it provides about the impact of
a project on the liquidity of a firm, it should not be used exclusively as the sole measure
of the acceptability of a project.

d) Project Gamma is rejected using the payback period, but even without discounting the
cash flows it seems to have a high dollar return for the investment. You pay $7.5 million
and receive a total of $14 million in cash inflows. Unless the firm has a very high
discount rate, greatly lowering the present value of the last $5.5 million cash flow, this is
likely to be a positive NPV investment. To make absolutely sure though we would need to
calculate NPV.

e) Alpha and Gamma can only have a maximum of one IRR while Beta can have a
maximum of two IRRs. This is because Alpha and Gamma have conventional cash flows
that change sign once while Beta’s cash flows change sign twice. Note – this refers to
maximum – the actual number of IRRs may be less (including 0!).

A3. In the end it all depends on market expectations! One view would be that the market is likely
to react positively to Microsoft’s decision to abandon the project by selling LinkedIn, that is,
if the market believed that the firm was not throwing more money at an unsuccessful
acquisition by trying to integrate it with Office. Alternatively, one could also argue that there
would be a negative reaction if in the market’s perception the acquisition had been viewed as
being successful and the announcement had come as a total surprise to the market,
particularly in light of a significantly lower resale value for LinkedIn. It’s also important to
highlight here that the market reaction reflects expectations at a particular point in time.

B. Multiple Choice Questions

B1. B is correct. The IRR would not change as it is invariant to the scale of the project which has
doubled in this case. The NPV would increase (and would be double the original positive
NPV) because all cash inflows and outflows have doubled. The way to think about this point

Suggested Answers to Tutorial Questions for Topic 7’s Lecture 6

 is that you have effectively invested in the original project twice in terms of the cash flows
expected.

B2. C is correct. All the items of information are required to evaluate a project except the IRR.
This question is stressing that the NPV of the project is what should be used to determine the
acceptability of a project.

B3. B is correct. The payback period is regularly used by managers in the real world, typically in
conjunction with other methods such as the NPV and IRR methods.

B4. C is correct. The NPV of the project is:

B5. D is correct. The brute force method would be to plug each given discount rate and calculate
the NPV until one arrives at a zero NPV. A more informed approach is to use the information
from the previous question. Since the NPV at the required rate of return of 12% is positive the
IRR should be higher than 12% (why?). Using a discount rate of 14.6%, we get:

So, the IRR must be 17.3%. We can verify this as follows:

Suggested Answers to Tutorial Questions for Topic 7’s Lecture 7