Financing and Investment Analysis

PRACTICE 4: FINANCING AND INVESTMENT EXERCISES

Exercise 1

The company Osopanda Ltd. is considering making an investment, for which it has two offers. The first
offer (project A) involves an outlay of €16,653 and guarantees cash flows of €6,500 and €13,000 in the
first and second year of the investment, respectively. The second offer (project B) involves a much
higher outlay of €71,428, but will only last for one year, at the end of which it will obtain a cash flow of
€76,428.
With these data, you are asked to answer the following questions in a justified manner:
Indicate which offer the company will choose if it follows the Payback criterion (determine the payback
periods of both investments).
Study the degree of interest of each of the offers according to the opportunity cost of capital and the
possible Fisher Rates (i.e., which project is preferable not for a specific value of the interest rate, but
according to ranges of values that the interest rate, k, could take).

Exercise 2

A company wants to bring a product to the market and needs to make an investment for a new plant.
The project will take 3 years and the following information is available:
 The investment amounts to €250,000.
 A production level of 10,000 units and an increase in production of 10% over the previous year in
each of the next two years is foreseen.
 The cost of raw materials is €15/unit.
 Additional operators are to be hired at an annual cost of €30,000.
 Also, a machinery maintenance contract will be signed at a cost of €3,000/year, and a new
warehouse will be rented at a cost of €10,000/year.
 The company estimates that it will be able to sell the machinery at the end of three years for
€15,000.
The cost of capital is 6%.
Using these data, answer:
a) What is the minimum price at which the products must be sold for the project to be profitable?
Establish without performing calculations, how the following facts affect:
b) f the interest rate rises above 6%, how will it affect its Net Present Value (NPV)? And its IRR? And
the minimum selling price?
c) If there is a technical problem and the production capacity can only increase by 5% per year,
how will it affect its Net Present Value? And its IRR? And the minimum selling price?

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 Financing and Investment Analysis

Exercise 3

The managers of a company have to decide between two investment projects, whose cash flows (in
thousands of euros) are shown in the following table:

PROJECT YEAR 0 YEAR 1 YEAR 2

A -18.658 23.614 3.500

B -10.000 5.000 13.500

Considering that the cost of capital is unknown, which investment is preferable according to the Payback
Period, Internal Rate of Return (IRR) and Net Present Value (NPV) valuation methods?
NOTE: In the case of the analysis of the Net Present Value (NPV) system, it should not be done for a
specific value of the interest rate, k, but for all the values that it could take (mathematically, between 0
and infinity). Consider all possible values of k in intervals of values for which the project preference is the
same.

Exercise 4

A company wants to advance the payment of a debt it has contracted. The contract stipulates that it
must make two payments (principal + interest), one of €300,000 and the other of €500,000 in 5 and 8
years, respectively. The intention is to pay off the debt early in two equal payments, to be made at the
end of the first and second year. How much would these payments be if the interest rate applied to the
loan at the time was 6%?

Exercise 5

The financial director of the company Lavamax Corporation, dedicated to the distribution and sale of
household appliances, receives the following proposal from a manufacturer of washing machines:
"Our usual payment formula is to receive the amount of the goods we sell you 90 days after delivery.
However, as your order is very interesting (€500,000), we can give you a 3% discount on the invoice if
you pay in cash (cash discount)".
Lavamax Corporation does not have more than the necessary cash for small expenses, but it has a credit
line open in its bank, for which the financial entity is charging it (whether or not it uses the money) 0.2%
per annum. The interest rate charged by the bank for the amounts withdrawn is 4.2% per annum
(including the already mentioned cost of the line of credit).
What decision should the financial director make?

Exercise 6

The opening of a bus service from Corsham to Heathrow Airport requires the acquisition of a minimum
of 2 buses which, fully equipped, represent a total investment of 1,000,000 €, with a useful life of 4
years. Each bus has 60 passenger seats, with a price per trip of €25. The variable cost per trip is €500.
Each bus will make two trips per day, one outbound and one return trip, every day of the year.

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 Financing and Investment Analysis

The expected average occupancy rate is 50% in the first year, 60% in the second year, 70% in the third
year and 80% in the fourth year.
a) What is the Net Present Value of the Corsham  Heathrow Airport line, for an expected cost of
money of 10%?
b) The company expect to recover the money invested in a maximum term of 3 years; according to
the forecasts, will it achieve it? (quantify the answer by calculating the investment recovery
period).
NOTE: Consider that a year has 360 days.

Exercise 7

In an investment project to be carried out in four years for the purchase of machinery, the following
information is available:
 Initial investment of €125,000.
 The net income generated by the production of the machinery during those four years is
€45,000, €55,000, €40,000 and €35,000, respectively.
 A contract is established for the maintenance of the machinery, amounting to €3,000/year.
Additionally, in the second year the machinery suffers a breakdown that is not contemplated in
the maintenance contract and the repair has an additional cost of €2,000.
 The machinery at the end of its 4-year useful life is sold for scrapping for €10,000.
 The annual discount rate is 10%.
a) Calculate the NPV of the project.
b) Reason (it is not necessary to calculate the value) how the following facts would affect the
project:
1. Given a possible change in the discount rate to the project's Internal Rate of Return (IRR).
Is the IRR greater than, less than or equal to 10%?
2. If the cash flows were the same, but they would be delayed by one year each, as well as
the useful life of the machinery, what would happen to the NPV and IRR?
3. If the project were required to have a payback of less than 3 years, would it be met?
4. If there were a residual value at the conclusion of the project, as is the case, how does it
affect the NPV?

Exercise 8

What is the maximum amount we should invest in a project at time 0 if the estimated cash inflows are
€30,000 per year, for 4 years from year 1?
The internal rate of return has been estimated to be 8%.

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 Financing and Investment Analysis

Exercise 9

Let be the cash flows of two investments:

INVESTMENTS YEAR 0 YEAR 1 YEAR 2

A -1.000 1.000 1.000

B -100.000 65.000 65.000

Where k = 13%.
a) Comment the result of calculating NPV and IRR.
b) Draw the graph of NPV and IRR for different values of k. Comment if Fisher's intersection exists
and its effect.

Exercise 10

Two projects, A and B, have a Fisher rate equal to 5% and the IRR B < IRRA. The investor must choose one
of the two projects (assumption: NPV linear and decreasing with respect to interest i, for both projects).
Answer the following questions:
a) Which project is better for: Fisher rate < i < IRRB?
b) Which project is better for: i < Fisher rate?
c) Which project is better for: IRRB < i < IRRA?

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