a) This question relates to alternative investment choice techniques
Stanley Livingstone is considering the following cash flows for two mutually exclusive projects.
Year Cash Flows, Investment X ($) Cash Flows, Investment Y ($)
0 -40,000 -40,000
1 12,000 18,000
2 18,000 18,000
3 27,000 18,000
You are required to answer the following questions:
i) If the cash flows after year 0 occur evenly over each year, what is the payback period for each project, and on this basis, which project would you prefer?
IN THE REMAINING PARTS, ASSUME THAT ALL CASH FLOWS OCCUR AT THE END OF EACH YEAR.
ii) Would the payback periods then be any different to your answer in i)? If so, what would the payback periods be?
iii) Sketch freehand the net present value (NPV) profiles for each investment on the same graph. Label both axes and the NPV profile for each investment.
iv) Calculate the internal rate of return (IRR) for each project and indicate them on the graph. [NOTE: It is satisfactory if the approximate IRR is calculated for Investment X by trial and error, and stated as a percentage correct to the nearer whole number. The IRR for Investment Y should be calculated as a percentage exactly, correct to 1 decimal place.]
v) Calculate the exact crossover point and indicate it on the above graph.
vi) State which of the investments you would prefer, depending on the required rate of return (i.e., depending on the discount rate).
b) This question relates to the valuation of bonds.
Bradley White, a retired school teacher, has two 6 per cent per annum $100,000 Australian Government bonds that mature on 15 August, 2020 and 15 August, 2023 respectively. At the date of the last half-yearly interest payment, viz., 15 February, 2017, both bonds were selling at par.
Since then, interest yields on bonds have risen by 2% per annum, compounded half-yearly. Bradley now intends to sell the bonds and put a deposit on a suburban townhouse.
i) Calculate the price he will receive from each bond if he sells on 15 August, 2017 at the new yield, immediately after receiving the interest payments due that day.
ii) Explain the relative price movements in the two bonds, as evidenced in your answer to i) above.
iii) Suppose that Bradley defers buying the bonds for 84 days, that is until 7 November, 2017. How much will he pay for each bond on that day? [NOTE: Between the bond interest due dates from mid-August to mid-February is 184 days, during which time interest accrues on a compound basis.]
This question relates to capital budgeting.
Perth Projects Ltd is considering the purchase of new technology costing $600,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 4 years.
The new technology will permit the company to reduce its to reduce its labour costs by $200,000 a year for 4 years, and the technology may be depreciated for tax purposes by the straight-line method to zero over the 4 years. The company thinks that it can sell the technology at the end of 4 years for $30,000.
The technology will need to be stored in a building, currently being rented out for $40,000 a year under a lease agreement with 4 yearly rental payments to run, the next one being due at the end of one year. Under the lease agreement, Perth Projects Ltd can cancel the lease by paying the tenant (now) compensation equal to one year’s rental payment plus 10%, but this amount is not deductible for income tax purposes.
This is not the first time that the company has considered this purchase. Twelve months ago, the company engaged Marvel Consultants, at a fee of $30,000 paid in advance, to conduct a feasibility study on savings strategies and Marvel made the above recommendations. At the time, Perth P:rojects did not proceed with the recommended strategy, but is now reconsidering the proposal.
Perth Projects further estimates that it will have to spend $20,000 in 2 years’ time overhauling the technology. It will also require additions to current assets of $30,000 at the beginning of the project, which will be fully recoverable at the end of the fourth year.
Perth Projects Ltd’s cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
(a) Calculate the net present value (NPV), that is, the net benefit or net loss in present value terms of the proposed purchase costs and the resultant incremental cash flows.
[HINT: As shown in the text-book, it is recommended that for each year you calculate the tax effect first, then identify the cash flows, then calculate the overall net present value.]
(b) Should the company purchase the technology? State clearly why or why not.