Question

1. Your friend Nigel is a management graduate and therefore has little chance of finding a job outside the fast-food industry. Luckily for him, Nigel's rich uncle has left him $20 million in his will. Having been a management student, Nigel partied while you studied. In fact, he took no courses in finance and thus knows nothing about investment. In a drunken stupor, late one Saturday night Nigel watched an interview with the Guru Jack ma. The Guru claims material wealth lies beneath the ground in Melbourne. It is clear from the tone of the interview, the title of the documentary was "An interview with a crackpot," that the interviewer and the "experts" on the show think the Guru is insane. However, Nigel believes in the Guru because his management training taught him to believe in gurus (Peter Drucker, for example). Nigel decides to use his new-found fortune to prove the Guru correct, making himself one of the richest people in Australia in the process! Nigel knows you have superior intellect (otherwise you wouldn't be in Finance) and asks you to work out the details. After some discreet investigation you find the homes and land can be purchased for $15 million. In addition, the local council insist on a $4 million fee for defacing the views from the city. Finally, it costs $1 million to lease the mining equipment. You and Nigel meet with the Guru and after several hours of meditation the Guru provides you with estimated annual after-tax cash-flows. These cash-flows are in millions and are provided to you below in table 2-1. Nigel thinks the cash-flows sound fantastic (compared to a career flipping burgers. Who wouldn't), you however decide to check the numbers using what you have learned in Finance. You believe the project is very risky and therefore in consultation with Westpac Bank Risk Management team decide to use a discount rate of 23%.

1. Should Nigel invest his fortune based on the crackpot's ideas?

2. Would your decision change if you used a discount rate of 18% or 10% ? Support the answer with the NPV and IRR.

              Table 2-1

	Projected Cashflow		Projected Cashflow
Year 1	$1,500,000	Year 11	$2,500,000
Year 2	$3,278,000	Year 12	$2,500,000
Year 3	$5,000,000	Year 13	$2,500,000
Year 4	$6,450,000	Year 14	$2,500,000
Year 5	$2,500,000	Year 15	$2,500,000
Year 6	$2,500,000	Year 16	$2,500,000
Year 7	$2,500,000	Year 17	$2,500,000
Year 8	$2,500,000	Year 18	$2,500,000
Year 9	$2,500,000	Year 19	$2,500,000
Year 10	$2,500,000	Year 20	$2,500,000

               Projected Cash Flows

Answer 1

Answe comprise both handwritten image and typed para below it. Please read both. (Plese provide feedback:)

(i) The NPV of the project at discount rate equal to 23% is -$6.53million. The investor should notgo forward with the contract. IRR of the project is 14.28%. Unless the discount rate which also represents riskyness of the project is below the IRR, the peoject is not worth investing.

(ii) When discount rate is 18%which is more than IRR of 14.28%, the NPV is -$3.35million. Don't invest.

When discount rate is 10% which is less than IRR of 14.28%, the NPV is $5.59million. Invest.

Thus, when discount rate falls below the IRR then project is worthwhile to invest.