Question

Consider a hypothetical economy that has NO tax. ABC Ltd. is considering investing in a 2-year project which is expected to generate the following year-end cash flows: C1 = $110 million, C2 = $115 million. The yearly discount rate for the project is 10%. The initial cost of the project is $200 million. (a) Compute the profit and NPV of the project. (b) Based on the answer of part (a), should the project be accepted? Explain. (c) ABC’s cut-off period is 2 years. Compute the PI and Payback of the project. Based on these two methods, should ABC accept the project? (d) Write down the numerical formula for computing the IRR of this project. What is the minimum IRR value that would make this project acceptable? Explain. (e) Given the recommendations based on the four decision rules above, which project should ABC Ltd. accept? (f) Now suppose that of the $200m initial expenditure, $50m was used for the purchase of a machine that has an estimated economic life of four years. The machine will be fully depreciated (i.e., zero book value at the end of the machine’s economic life) on a straight-line basis and expected to have a resale value of $35m at the end of the project. (i) Explain how this will affect the size of the terminal (end-of-project) cash flows. (ii) How will this affect the NPV and the acceptance/rejection of the project (as compared to part (a))? Show your calculations. Question 3 (25 marks/Bond and Equity Valuation) Bond A is a $1,000, 6% quarterly coupon bond with 5 years to maturity. (a) If you bought Bond A today at a yield (APR) of 8%, what is your purch

Answer 1

Consider a hypothetical economy that has NO tax.
ABC Ltd. is considering investing in a 2-year project,
Year-end cash flows: C1 = $110 million, C2 = $115 million.
The yearly discount rate for the project is 10%.
The initial cost of the project is $200 million.

(a) Compute the profit and NPV of the project. (4 marks)

(A) Project - ABC Ltd.
Computation Of PV Of CIF (in Million)
Years	Cash Flows	Pv factor @10.00%	PV in $
0	($200)	1.0000	$ (200.00)
1	$110	0.9091	$   100.00
2	$115	0.8264	$      95.04
salvage value	$0	0.0000	$             -
Profit	$ 25.00	N.P.V.	$     (4.96)

(b) Based on the answer of part (a), should the project be accepted? Explain. (3 marks)
= Based On Answer Of (A), I should not recommand project due to negative NPV. Profit is $25 Million, but Actually value of NPV is in loss (4.96) millions, Which is "Not Accepted."

(c) ABC’s cut-off period is 2 years. Compute the PI and Payback of the project. Based on these two methods, should ABC accept the project? (6 marks)
(i)Computation Of PI (Profitability Index)
= PV of Future cash flows / initial Investments
= $(4.96) / $200 *100
= -2.48%
(ii)Computation Of Payback of the project :
The payback period refers to the amount of time it takes to recover the cost of an investment.
Here Almost 2 years to recovers initial investment, ignoring Time factors value.
Suggestion : Not To accept project, due to negative PI & payback period is almost same for project duartion

(d) Write down the numerical formula for computing the IRR of this project.
What is the minimum IRR value that would make this project acceptable? Explain. (5 marks)
IRR : To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate (r), which is the IRR.
However, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.
Here we tried trail N error methods, n get that IRR is somewhere in between 8% & 9%
Now Finding Exact IRR, By following ways,
= 8% + ($0.45 million - $200 million)/($0.45 million - (-$2.29)) *1%  
= 8% + ($199.55)/($2.74) *1%
= 8% + (0.16)%
= 8.16% where NPV is become Zero....

(e) Given the recommendations based on the four decision rules above, which project should ABC Ltd. accept? (2 marks)
= Based on above decision, Project should be accepted only if cost of capital is less than or equal to 8.16%, otherwise it may be loss making project at later period.

(f) Now suppose that of the $200m initial expenditure, $50m was used for the purchase of a machine that has an estimated economic life of four years. The machine will be fully depreciated (i.e., zero book value at the end of the machine’s economic life) on a straight-line basis and expected to have a resale value of $35m at the end of the project.
(i) Explain how this will affect the size of the terminal (end-of-project) cash flows. (2 marks)

Computation Of PV Of CIF (in Million)
Years	Cash Flows	Pv factor @10.00%	PV in $
0	($200)	1.0000	$ (200.00)
1	$110	0.9091	$   100.00
2	$115	0.8264	$      95.04
salvage value	$35	0.8264	$      28.93
Profit	$ 60.00	N.P.V.	$     23.97

(ii) How will this affect the NPV and the acceptance/rejection of the project (as compared to part (a))? Show your calculations. (3 marks)
Effect On NPV = $28.93 =($23.97 - (-$4.96) million excees amt of inflow, as compared to part (A),
Now Project is more easy to accept, due to positive NPV, $23.97 millions.