MFIN7005 2023-24

Solution to Assignment-4

Q.1
The annual depreciation charge is $400,000/10 = $40,000. The after-tax operating cash
flow in Year 1 should be
𝐶𝐹 = (𝑆 − 𝐶 − 𝐷) × (1 − 𝑇) + 𝐷
= (240,000 − 110,000 − 40,000) × (1 − 0.3) + 40,000
= 63,000 + 40,000 = $103,000

Q.2
As shown in the table below, the cumulative cash flow offsets the initial investment in
exactly three years. The payback period is three years. The discounted payback period is
between four and five years. The discounted payback period is four years plus
24.09/3,402.92 = 0.007 of the fifth year cash flow, or 4.007 = 4.01 years. The discounted
payback period is 4.01 ‒ 3.00 = 1.01 years longer than the payback period.

Year 0 1 2 3 4 5
Cash flow ‒50,000 15,000 15,000 20,000 10,000 5,000
Cumulative cash flow ‒50,000 ‒35,000 ‒20,000 0 10,000 15,000
Discounted cash flow ‒50,000 13,889 12,860 15,877 7,350 3,403
Cumulative DCF ‒50,000 ‒36,111 ‒23,251 ‒7,374 ‒24 ‒3,379

Q.3
The decision is to invest in Project 2 because it has the higher NPV. When valuing mutually
exclusive projects, the decision should be made with the NPV method because this method
uses the most realistic discount rate, namely the opportunity cost f funds. In this example,
the reinvestment rate for the NPV method (here 10%) is more realistic than the
reinvestment rate for the IRR method (here 16.37% or 15.02%).

Q.4
The effect on the project NPV is an increase of $199,674.

The decrease in annual depreciation is $250,000/10=$25,000. Additional tax due to

lower depreciation is 0.30  ($25,000) = $7,500 per year. The change in project NPV is
10
7,500
250.000 − ∑ = 250,000 − 50,326 = $199,674
(1.08)𝑡
𝑡=1
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 MFIN7005 2023-24
Solution to Assignment-4

Q.5
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐷1 /𝑃0 + 𝑔 = $0.50/$10 + 5% = 5% + 5% = 10%
𝐷 0.75
= = 0.4286
𝐷 + 𝐸 1.75
𝑊𝐴𝐶𝐶 = 0.4286 × 0.06 × (1 − 0.25) + (1 − 0.4286) × 0.1 = 7.64%

Q.6

1
𝐴𝑠𝑠𝑒𝑡 𝑏𝑒𝑡𝑎 = 1.25 × ( )=1
5,000
1 + (1 − 40%) × 12,000

𝛽𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑇𝐴𝑅 = 1 × (1 + (1 − 25%) × 30%) = 1.225

Q.7
(a) The net investment outlay is $840,000.
𝑂𝑢𝑡𝑙𝑎𝑦 = 𝐹𝐶𝐼𝑛𝑣 + 𝑁𝑊𝐶𝐼𝑛𝑣 − 𝑆𝑎𝑙0 + 𝑇(𝑆𝑎𝑙0 − 𝐵0 )
𝑂𝑢𝑡𝑙𝑎𝑦 = ($500,000 + $140,000) + $200,000 − $0 + $0 = $840,000

(b) The incremental annual after-tax operating cash flow is $250,000. The installed cost
is $500,000+$140,000 = $640,000, so the annual depreciation is $640,000/4 = $160,000.
The annual after-tax operating cash flow for Years 1-4 is
𝐶𝐹 = (𝑆 − 𝐶 − 𝐷)(1 − 𝑇) + 𝐷
= ($400,000 − $120,000 − $160,000) × (1 − 0.25) + $160,000 = $250,000

(c) The terminal year after-tax non-operating cash flow at the end of Year 4 is $260,000.
𝑇𝑁𝑂𝐶𝐹 = 𝑆𝑎𝑙5 + 𝑁𝑊𝐶𝐼𝑛𝑣 − 𝑇(𝑆𝑎𝑙5 − 𝐵5 )
= $80,000 + $200,000 − 0.25 × ($80,000 − $0) = $260,000

(d) The project’s NPV is $179,139.

4
$250,000 $260,000
𝑁𝑃𝑉 = −$840,000 + ∑ + = $179,139
1.08𝑡 1.084
𝑡=1

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Solution to Assignment-4

Q.8
Market value of debt: FV=$32,000,000, PMT=$480,000, N=16, Yield=7.8353%. Solving
for PV gives $29.999.949.

Market value of equity: 3.5 million shares outstanding @ $20 = $70,000,000.

Market value of debt $29,999,949 30%
Market value of equity $70,000,000 70%
Total capital $100,000,000 100%
To raise $50 million of new capital while maintaining the same capital structure, the
company would issue $50 million × 30% = $15 million in bonds, which results in a before-
tax rate of 10%.

𝑟𝑑 (1 − 𝑡) = 0.10 × (1 − 0.25) = 0.075 𝑜𝑟 7.5%

𝑟𝑒 = 0.02 + 1.5 × (0.08 − 0.02) = 0.11 𝑜𝑟 11%
𝑊𝐴𝐶𝐶 = 0.3 × 0.075 + 0.7 × 0.11 = 0.0225 + 0.077 = 0.0995 𝑜𝑟 9.95%

Q.9
Since either project, if chosen, will be replaced repeatedly when it wears out, to evaluate
between the two projects, it is not sufficient to consider only one project cycle. As the two
projects have different project lives, it needs to align the cash flows of both projects for
comparison.

(a)
The least common multiple of 5 years (for Project X) and 3 years (for Project Y) is 15 years.

In 15 years, Project X will have 3 cycles with total NPV as follows:

$𝟓𝟎𝑴 $𝟓𝟎𝑴
𝑵𝑷𝑽𝑿(𝑹) = $𝟓𝟎𝑴 + + = $𝟏𝟏𝟗. 𝟖𝟕𝑴
(𝟏 + 𝟓%) 𝟓 (𝟏 + 𝟓%)𝟏𝟎

In 15 years, Project Y will have 5 cycles with total NPV as follows:

$𝟑𝟑𝑴 $𝟑𝟑𝑴 $𝟑𝟑𝑴 $𝟑𝟑𝑴

𝑵𝑷𝑽𝒀(𝑹) = $𝟑𝟑𝑴 + 𝟑
+ 𝟔
+ 𝟗
+ = $𝟏𝟐𝟓. 𝟕𝟖𝑴
(𝟏 + 𝟓%) (𝟏 + 𝟓%) (𝟏 + 𝟓%) (𝟏 + 𝟓%)𝟏𝟐

As the total NPV of Project Y in 15 years is higher than that of Project X, it is more desirable
to choose Project Y between the two projects under the condition that the company’s

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 MFIN7005 2023-24
Solution to Assignment-4

capital budget is restricted by limited amount of available capital.

(b)
Project X’s equivalent annual annuity 𝐸𝐴𝐴(𝑋)
𝑬𝑨𝑨(𝑿) 𝑬𝑨𝑨(𝑿) 𝑬𝑨𝑨(𝑿) 𝑬𝑨𝑨(𝑿) 𝑬𝑨𝑨(𝑿)
𝑵𝑷𝑽𝑿 = + + + +
(𝟏 + 𝑹𝑹𝑹) (𝟏 + 𝑹𝑹𝑹)𝟐 (𝟏 + 𝑹𝑹𝑹)𝟑 (𝟏 + 𝑹𝑹𝑹)𝟒 (𝟏 + 𝑹𝑹𝑹)𝟓
𝑹𝑹𝑹
𝑬𝑨𝑨(𝑿) = 𝑵𝑷𝑽𝒙 ×
𝟏
𝟏 − (𝟏 + 𝑹𝑹𝑹)𝟓

𝟓%
𝑬𝑨𝑨(𝑿) = $𝟓𝟎𝑴 × 𝟓
= $𝟏𝟏. 𝟓𝟓𝑴
𝟏
𝟏−( )
𝟏 + 𝟓%

Project Y’s equivalent annual annuity 𝐸𝐴𝐴(𝑌)

𝑬𝑨𝑨(𝒀) 𝑬𝑨𝑨(𝒀) 𝑬𝑨𝑨(𝒀)
𝑵𝑷𝑽𝒀 = + +
(𝟏 + 𝑹𝑹𝑹) (𝟏 + 𝑹𝑹𝑹)𝟐 (𝟏 + 𝑹𝑹𝑹)𝟑
𝑹𝑹𝑹
𝑬𝑨𝑨(𝒀) = 𝑵𝑷𝑽𝒀 ×
𝟏
𝟏 − (𝟏 + 𝑹𝑹𝑹)𝟑

𝟓%
𝑬𝑨𝑨(𝒀) = $𝟑𝟑𝑴 × 𝟑 = $𝟏𝟐. 𝟏𝟐𝑴
𝟏
𝟏−( )
𝟏 + 𝟓%

As the equivalent annual annuity of Project Y is higher than that of Project X, it is more
desirable to choose Project Y between the two projects under the condition that the
company’s capital budget is restricted by limited amount of available capital.

(Sources : CFA)
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