MSc 2004 - Corporate Finance.

Investment Appraisal- Practice Questions.

1.  A firm is considering investing in a project with the following cashflows. The firm has a cost of capital of 10%.

0 / 1 / 2 / 3 / 4 / 5
-1000 / 600 / 300 / 200 / 150 / 150

Calculate the NPV. Should the project be taken?

Calculate the IRR by trial and error. Compare the NPV and IRR graphically.

2.  2. A firm is considering investing in a new 5 year project. The new project will require initial investment of £300,000, depreciated on a straight line basis. There is no corporation tax. The project will result in the following incremental cashflows per annum.

Units / Price/Unit
Revenue / 100,000 / £2
Direct Labour / 5 units produced per manhour / £4 per manhour
Direct Materials / 100,000 / £0.10

In addition, the project will attract £4 per unit of existing overheads. The firm has just undertaken a feasibility study for this project, costing £5000. The firm has a cost of capital of 12%.

What is the NPV of the project? Should the project be taken?

Using the interpolation method, calculate the IRR.

3.  Consider the same problem as in 2, but now there is corporation tax of 25%.

4.  A firm is considering the following mutually exclusive projects.

YEAR / A / B / C
0 / -1000 / -1000 / -1000
1 / 400 / 200 / 250
2 / 600 / 300 / 250
3 / 200 / 500 / 250
4 / -300 / 300 / 250
5 / -400 / 300 / 250

a)  Calculate the NPV of each project, given that the cost of capital is 10%.

b)  Plot NPV against different discount rates for project A.

c)  Calculate the IRRs of each project by trial and error.

d)  Calculate the paybacks of each project.

e)  Compare the IRRs, NPVs, and paybacks and comment.

f)  Which project should be taken? Justify your choice of decision rule.

5.  A firm is appraising a new investment, requiring initial outlay of £900. It is expected to provide annual revenue of £1000, with annual variable costs equal to 60% of revenue, and annual fixed cost of £300, every year forever. Calculate the NPV, given a discount rate of 10%.

6. a) A new 3 year project, project A, will provide the following incremental cashflows in year 1, subject to inflation as shown.

Date 1 / Inflation P.A.
Revenue / 100,000 / 5%
Variable Costs / 50% of revenue / 5%
Fixed Costs / 20,000 / 5%

The date 0 outflow is £35000. The nominal cost of capital is 10%. Calculate the NPV of the project.

6.  Firm X is bidding to win a contract to supply 1000 widgets per annum to a customer. If it wins the contract, the project will last into the foreseeable future (that is, it can be treated as a perpetuity). The project will require initial investment of £1,000, 000. Variable production cost per unit for firm X will be £5. There are no fixed costs, and no tax. The firm has a cost of capital of 10%.

Firm X is competing against other firms for the contract in a sealed-price bid. Firm X wishes to maximise its chances of winning the contract by submitting the lowest possible bid price without reducing shareholder wealth. Find this bid price.

If firm X submitted a lower bid price than this, and it won the contract, what should immediately happen to the share price?