FNCE10002 Principles of Finance Semester 2, 2024
FNCE10002 Principles of Finance
Semester 2, 2024
Capital Budgeting II
Tutorial Questions for Topic 8’s Lecture
Priority Questions:
A1, A2, B3
A. Short Answer Questions
Provide brief responses to the following questions.
A1.TXT Answer each part separately.
a) To finance a certain project, a company must borrow funds at 10 percent interest. How
should it treat interest payments when it analyzes the project’s cash flows? Explain.
b) What are the tax consequences of selling an investment asset for more than its book
value? Does this have an effect on project cash flows? What is the effect if the asset is
sold for less than its book value? Explain.
c) Why must incremental after-tax cash flows rather than total cash flows be evaluated in
project analysis? Explain.
d) Differentiate between sunk costs and opportunity costs. Which of these costs should be
included in incremental cash flows, and which should be excluded? Explain.
e) Why is it important to consider cannibalization in situations where a company is
considering adding substitute products to its main product line? Explain.
A2.EXM For each statement indicate whether it is true or false and briefly explain why.
a) The weighted average cost of capital will lie between the cost of debt and cost of equity
of the firm.
b) Once the weighted average cost of capital has been estimated it is unlikely that it will
change if the risks associated with the projects a firm invests in do not change.
c) When evaluating a project, the weighted average cost of capital necessarily requires that
the internal rate of return also be calculated for comparison purposes.
Tutorial Questions for Topic 8’s Lecture 1
FNCE10002 Principles of Finance Semester 2, 2024
B. Problems
B1. KLP Ltd is deciding whether to expand its production facility located in Melbourne. The
expansion will cost $30 million and management has projected the following cash flows (in
millions of dollars) associated with the first two years of the project.
Year 0 Year 1 Year 2
Revenues $100.0 $160.0
Operating costs (ex. Depreciation) $50.0 $60.0
Depreciation $14.0 $12.0
Increase in net working capital $4.0 $8.0
Capital expenditure $30.0 $0.0 $0.0
Marginal corporate tax rate 30% 30%
a) Calculate the incremental after-tax earnings for this project in years 1 and 2.
b) Calculate the net after-tax cash flows (that is, free cash flows) for this project in years 1
and 2.
B2.EXM Digem Mines must choose between two alternative machines A and B which perform
the same function, but which have lives of 2 and 4 years, respectively. The initial cost of
machine A is $30,000 and its annual operating costs are expected to be $6,000. The initial
cost of machine B is $42,000 and its annual operating costs are expected to be $9,000.
Assume that the projects are repeatable and there are no constraints on the availability of
funds. Digem will use a discount rate of 10% p.a. to evaluate the two machines.
a) Calculate the net present values of the two machines using the constant chain of
replacement assumption and the lowest common multiple method. Which machine should
Digem choose and why?
b) Redo your analysis in part (a) using the constant chain of replacement assumption and the
perpetuity method. Which machine should Digem choose now? Comment on any
differences between the method used here and that used in part (a).
B3.EXM STR Ltd has 12,000 bonds outstanding, each with a face value of $100. The bonds
pay an annual coupon of 12% and the most recent coupon has just been paid. The bonds will
mature in 6 years and currently have a yield to maturity of 15%. It has 100,000 preference
shares outstanding which are currently trading at $8.75. The dividend rate on the preference
shares is 14% and each share has a face value of $10. It also has 2 million ordinary shares
outstanding which are currently trading at $3.06. STR has just paid a dividend of $0.50, and
investors expect earnings and dividends to grow to a constant rate of 4 percent in the
foreseeable future. There are no company taxes and management considers its present capital
structure to be optimal and has no plans to change it.
a) Determine the cost of the various capital components and STR’s before-tax weighted
average cost of capital.
b) You show your calculations to a colleague, who argues that the dividend growth model is
an unreliable way of estimating the cost of equity capital. She suggests you use the capital
asset pricing model. You take her advice and you estimate STR’s beta to be 1.8, the risk-
free rate to be 5% and the expected market risk premium to be 8%. Calculate STR’s new
before-tax weighted average cost of capital.
Tutorial Questions for Topic 8’s Lecture 2
FNCE10002 Principles of Finance Semester 2, 2024
C. Closing the loop with some selected finance research
Professor John Graham is the D. Richard Mead Professor of Finance at the Fuqua School of Business
at Duke University and as well as being one of the most accomplished researchers in corporate
finance over the last 20+ years, is also co-author of the prescribed text for this subject! In 2021 he
was President of the American Finance Association (which is widely considered the peak academic
body in finance) and as part of his duties he gave the Presidential Address in 2022 which was titled
“Presidential Address: Corporate Finance and Reality” where he reviews a substantial body of survey
literature that documents how finance practitioners make decisions in practice.
You can access the paper he presented here.
One part of the paper touched upon the observed differences between the rate of return used by firms
to evaluate projects (the so called “hurdle rate”) and the firm’s Weighted Average Cost of Capital
(WACC). Here is an excerpt from that paper [Graham, J. R. (2022). Presidential Address: Corporate
Finance and Reality. NBER Working Paper, (w29841), Figure 3, page 14]:
a) Looking at the figure above, what is the significance of firm’s using hurdle rates that are
systematically different to their WACC?
b) Consider the following quote “Evidence suggests that managerial job prospects and reputation
are penalized proportionally more for downside misses than they are rewarded for upside
success; therefore , in this paper I primarily focus on the effects of downside surprises.” [third
para, page 3]. Briefly explain the link between this quote and the evidence presented in
Figure 3.
Tutorial Questions for Topic 8’s Lecture 3
FNCE10002 Principles of Finance Semester 2, 2024
FNCE10002 Principles of Finance
Semester 2, 2024
Capital Budgeting II
Suggested Answers to Tutorial Questions for Topic 8’s Lecture
A. Short Answer Questions
A1. a) Interest expense should be ignored and should not be treated as a cash outflow. The
discount rate already captures the costs associated with financing a project and deducting
these costs from the project’s cash flows would be double counting.
b) If an investment is sold for more than its book value, then the firm has a capital gain on
the difference between market price and book value and must pay capital gains taxes on
that difference. The cash flows are the market price of the investment sale minus the
additional taxes. If an asset is sold for less than book value, then the company can claim a
tax credit on the difference between the market price and the book value. This credit is
the difference between market value and book value times the tax rate. The cash flows are
the market price of the asset plus the tax credit.
c) Incremental cash flows matter because the project evaluator is looking at what will
change if the project is accepted. Any existing expenses that the company would pay
whether or not it accepted the project are not relevant to the decision at hand. The
evaluator must look at what changes will occur if a project is accepted.
d) Sunk costs should not be included in a cash flow analysis. These are costs that have
already been paid. Accepting or rejecting the project will not impact these costs. These
are not incremental to the project. Opportunity costs may be relevant depending on the
question that you are trying to answer. For example, if the question is “What is the wealth
impact of on company of accepting this project?” then the cash flows associated with an
alternative mutually exclusive project (the opportunity cost) are not relevant – as you are
evaluating the project on a stand-alone basis. If, however, you are answering the question
“What is the incremental wealth impact of Project A over and above Project B?” then the
cash flows associated with Project B would be relevant to the decision.
e) Cannibalization is the ‘substitution effect’ that frequently occurs when a firm introduces a
new product. Typically, some of the new product’s sales will come at the expense of the
firm’s existing products. Therefore, it is very important to consider the incremental cash
outflows from existing product sales that are cannibalized by a newer product since they
will affect the calculation of the new investment’s incremental cash flows, respectively
the attractiveness of the venture.
Suggested Answers to Tutorial Questions for Topic 8’s Lecture 1
FNCE10002 Principles of Finance Semester 2, 2024
A2. a) True. The cost of capital is a weighted average of all the financing instruments used by
the firm.
b) False. The weighted average cost of capital reflects the optimal mix of debt, equity and
other financing instruments used by the firm. So, the weighted average cost of capital will
change as this optimal mix changes. Put another way – as the firm changes its mix of debt
and equity, WACC too will change.
c) False. The weighted average cost of capital does not require calculating the internal rate
of return as it can be used to discount the cash flows from a project which can then be
analyzed using the NPV method.
B. Problems
B1. The incremental net earnings (or net income) is as follows.
Net income = (Rt – OCt – Dt)(1 – tc).
Year 1 Year 2
Revenues $100.0 $160.0
Operating costs (ex. Depreciation) –$50.0 –$60.0
Depreciation –$14.0 –$12.0
Earnings before taxes (EBT) $36.0 $88.0
Less: Taxes (at 30%) –$10.8 –$26.4
Earnings after taxes (EAT) or Net income $25.2 $61.6
The net after-tax cash flows (or free cash flows) are as follows.
Year 1 Year 2
Net income $25.2 $61.6
Plus: Depreciation $14.0 $12.0
Less: Capital expenditure $0.0 $0.0
Less: Increase in net working capital –$4.0 –$8.0
Net after-tax cash flow $35.2 $65.6
B2. The two methods are illustrated below and they both give the same decision.
a) Using the common terminal date of 4 years, we have the net cash flows and NPVs as
follows. We would select machine B as it has the higher NPV.
Project A’s Cash PV of Cash Flow Project B’s Cash PV of Cash Flow
Year Flows (r = 10%) Flows (r = 10%)
0 –$30,000 –$30,000 –$42,000 –$42,000
1 –$6,000 –$5,455 –$9,000 –$8,182
2 –$6,000 – $30,000 –$29,752 –$9,000 –$7,438
3 –$6,000 –$4,508 –$9,000 –$6,762
4 –$6,000 –$4,098 –$9,000 –$6,147
NPV –$73,813 –$70,529
b) The NPVs of the projects are as follows.
Suggested Answers to Tutorial Questions for Topic 8’s Lecture 2
FNCE10002 Principles of Finance Semester 2, 2024
Project A’s Cash PV of Cash Flow Project B’s Cash PV of Cash Flow
Year Flows (r = 10%) Flows (r = 10%)
0 –$30,000 –$30,000 –$42,000 –$42,000
1 –$6,000 –$5,455 –$9,000 –$8,182
2 –$6,000 –$4,959 –$9,000 –$7,438
3 –$9,000 –$6,762
4 –$9,000 –$6,147
NPV –$40,413 –$70,529
The net present values are obtained using the following expression:
Again, we would select machine B as it has the higher NPV. Both methods are consistent
with each other and give the same decision.
B3. a) The costs of the capital components are as follows:
Cost and market value of bonds
The cost of debt is the yield to maturity is given as 15%.
The market price of the bonds is:
The market value of the bonds = 12000 88.65 = $1,063,800.
Cost and market value of preference shares
The market value of the preference shares is:
Market value of preference shares = 100000 8.75 = $875,000.
Cost and market value of ordinary shares
Suggested Answers to Tutorial Questions for Topic 8’s Lecture 3
FNCE10002 Principles of Finance Semester 2, 2024
So, rE = 21.0%.
The market value of the ordinary shares is:
Market value of ordinary shares = 2000000 $3.06 = $6,120,000.
Market value of the firm = 1063800 + 875000 + 6120000 = $8,058,800.
The firm’s weighted average cost of capital is:
rO = 19.66%.
b) Revised rE = 0.05 + (0.08)1.8 = 19.4%.
The firm’s revised weighted average cost of capital is:
rO = 18.45%.
Suggested Answers to Tutorial Questions for Topic 8’s Lecture 4
