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Financial Planning Problems




Question;6-1. Your;brother wants to borrow $10,000 from you. He has offered to pay you back;$12,000 in a year. If the cost of capital of this investment opportunity is;10%, what is its NPV? Should you undertake the investment opportunity?;Calculate the IRR and use it to determine the maximum deviation allowable in;the cost of capital estimate to leave the decision unchanged.6-2. You are considering investing in a start-up;company. The founder asked you for $200,000 today and you expect to get;$1,000,000 in nine years. Given the riskiness of the investment opportunity;your cost of capital is 20%. What is the NPV of the investment opportunity?;Should you undertake the investment opportunity? Calculate the IRR and use it;to determine the maximum deviation allowable in the cost of capital estimate to;leave the decision unchanged.;6-3. You;are considering opening a new plant. The plant will cost $100 million upfront.;After that, it is expected to produce profits of $30 million at the end of;every year. The cash flows are expected to last forever. Calculate the NPV of;this investment opportunity if your cost of capital is 8%. Should you make the;investment? Calculate the IRR and use it to determine the maximum deviation;allowable in the cost of capital estimate to leave the decision unchanged.;6-4. Your;firm is considering the launch of a new product, the XJ5. The upfront;development cost is $10 million, and you expect to earn a cash flow of $3;million per year for the next five years. Plot the NPV profile for this project;for discount rates ranging from 0% to 30%. For what range of discount rates is;the project attractive?;6-5. Bill Clinton reportedly;was paid $10 million to write his book My Way. The book took three years;to write. In the time he spent writing, Clinton;could have been paid to make speeches. Given his popularity, assume that he;could earn $8 million per year (paid at the end of the year) speaking instead;of writing. Assume his cost of capital is 10% per year.;a. What is the NPV of agreeing to write the;book (ignoring any royalty payments)?;b. Assume that, once the book is finished, it;is expected to generate royalties of $5 million in the first year (paid at the;end of the year) and these royalties are expected to decrease at a rate of 30%;per year in perpetuity. What is the NPV of the book with the royalty payments?;6-6. FastTrack Bikes, Inc. is;thinking of developing a new composite road bike. Development will take six;years and the cost is $200,000 per year. Once in production, the bike is;expected to make $300,000 per year for 10 years. Assume the cost of capital is;10%.;a. Calculate the NPV of this investment;opportunity, assuming all cash flows occur at the end of each year. Should the;company make the investment?;b. By how much must the cost of capital;estimate deviate to change the decision? (Hint: Use Excel to calculate;the IRR.);c. What is the NPV of the investment if the;cost of capital is 14%?;i.;6-8. You;are considering an investment in a clothes distributor. The company needs;$100,000 today and expects to repay you $120,000 in a year from now. What is;the IRR of this investment opportunity? Given the riskiness of the investment;opportunity, your cost of capital is 20%. What does the IRR rule say about;whether you should invest?;6-9. You;have been offered a very long term investment opportunity to increase your;money one hundredfold. You can invest $1000 today and expect to receive;$100,000 in 40 years. Your cost of capital for this (very risky) opportunity is;25%. What does the IRR rule say about whether the investment should be;undertaken? What about the NPV rule? Do they agree?;6-10. Does;the IRR rule agree with the NPV rule in Problem 3? Explain..;6-11. How many IRRs are there;in part (a) of Problem 5? Does the IRR rule give the right answer in this case?;How many IRRs are there in part (b) of Problem 5? Does the IRR rule work in;this case?;6-12. Professor;Wendy Smith has been offered the following deal: A law firm would like to;retain her for an upfront payment of $50,000. In return, for the next year the;firm would have access to 8 hours of her time every month. Smith?s rate is $550;per hour and her opportunity cost of capital is 15% (EAR). What does the IRR;rule advise regarding this opportunity? What about the NPV rule?;6-13. Innovation;Company is thinking about marketing a new software product. Upfront costs to;market and develop the product are $5 million. The product is expected to;generate profits of $1 million per year for 10 years. The company will have to;provide product support expected to cost $100,000 per year in perpetuity.;Assume all profits and expenses occur at the end of the year.;a. What is the NPV of this investment if the;cost of capital is 6%? Should the firm undertake the project? Repeat the;analysis for discount rates of 2% and 12%.;b. How many IRRs does this investment;opportunity have?;c. Can the IRR rule be used to evaluate this;investment? Explain.;6-14. You;own a coal mining company and are considering opening a new mine. The mine;itself will cost $120 million to open. If this money is spent immediately, the;mine will generate $20 million for the next 10 years. After that, the coal will;run out and the site must be cleaned and maintained at environmental standards.;The cleaning and maintenance are expected to cost $2 million per year in;perpetuity. What does the IRR rule say about whether you should accept this;opportunity? If the cost of capital is 8%, what does the NPV rule say?.;6-15. Your;firm spends $500,000 per year in regular maintenance of its equipment. Due to;the economic downturn, the firm considers forgoing these maintenance expenses;for the next three years. If it does so, it expects it will need to spend $2;million in year 4 replacing failed equipment.;a. What is the IRR of the decision to forgo;maintenance of the equipment?;b. Does the IRR rule work for this decision?;c. For what costs of capital is forgoing;maintenance a good decision?;6-16. You are considering;investing in a new gold mine in South;Africa. Gold in South Africa is buried very deep;so the mine will require an initial investment of $250 million. Once this;investment is made, the mine is expected to produce revenues of $30 million per;year for the next 20 years. It will cost $10 million per year to operate the;mine. After 20 years, the gold will be depleted. The mine must then be;stabilized on an ongoing basis, which will cost $5 million per year in;perpetuity. Calculate the IRR of this investment. (Hint: Plot the NPV as;a function of the discount rate.).;6-17. Your;firm has been hired to develop new software for the university?s class;registration system. Under the contract, you will receive $500,000 as an;upfront payment. You expect the development costs to be $450,000 per year for;the next three years. Once the new system is in place, you will receive a final;payment of $900,000 from the university four years from now.;a. What are the IRRs of this opportunity?;b. If your cost of capital is 10%, is the;opportunity attractive?;Suppose you are able to;renegotiate the terms of the contract so that your final payment in year 4 will;be $1 million.;c. What is the IRR of the opportunity now?;d. Is it attractive at these terms?;6-18. You are considering;constructing a new plant in a remote wilderness area to process the ore from a;planned mining operation. You anticipate that the plant will take a year to;build and cost $100 million upfront. Once built, it will generate cash flows of;$15 million at the end of every year over the life of the plant. The plant will;be useless 20 years after its completion once the mine runs out of ore. At that;point you expect to pay $200 million to shut the plant down and restore the;area to its pristine state. Using a cost of capital of 12%;a. What is the NPV of the project?;b. Is using the IRR rule reliable for this;project? Explain.;c. What are the IRR?s of this project?;6-19. You;are a real estate agent thinking of placing a sign advertising your services at;a local bus stop. The sign will cost $5000 and will be posted for one year. You;expect that it will generate additional revenue of $500 per month. What is the;payback period?.;6-20. You;are considering making a movie. The movie is expected to cost $10 million;upfront and take a year to make. After that, it is expected to make $5 million;when it is released in one year and $2 million per year for the following four;years. What is the payback period of this investment? If you require a payback;period of two years, will you make the movie? Does the movie have positive NPV;if the cost of capital is 10%?;Timeline


Paper#44736 | Written in 18-Jul-2015

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