FNCE20001
Business Finance
ASSIGNMENT 2
Semester 2, 2014
Prepared by
Vincent Grégoire
Department of Finance
Faculty of Business and Economics 2
FNCE20001 Business Finance
Assignment 2
Semester 2, 2014
ADMINISTRATIVE ARRANGEMENTS
Due date: 23.59pm on Monday October 13, 2014
Late
assignments:
Late submissions must be accompanied by a completed Request for
Special Consideration form. This form must be handed to the Commerce
Student Centre.
Late assignments, where approval for late submission has not been given,
will be penalised at the rate of 25% of the total mark per day, for up to 3
days, at which time a mark of zero will be given.
Special
Consideration:
Students who have been significantly affected by illness or other serious
circumstances during the semester may be eligible to apply for Special
Consideration through the commerce student centre
http://fbe.unimelb.edu.au/csc
Where to
submit:
The Assignment Tool allows you to submit your assignment online from
home or from any of the student labs on campus.
You can access the Assignment Tool by clicking on Assignment Tool in
the navigation menu from the LMS page for this subject. You will need to
submit your assignment electronically in PDF format (a requirement made
by the IT department).
Cover sheet: You should use the Assignment submission sheet provided on the LMS
page for your assignment submissions. This will enable us to easily
identify student submissions:3
Marks: This assignment counts 7.5% towards the final mark in this subject.
ASSIGNMENT INSTRUCTIONS
The assignment must be your own work. Students are encouraged to discuss the
assignment and to share information sources. However, the writing of each student’s
assignment must be conducted separately and independently. Where use has been made of
the work of others (for example, through your reading of books, articles or webpages)
appropriate recognition must be given via quotation marks and referencing. Failure to give
such recognition is plagiarism and will result in the annulment of your mark for the
assignment. Other disciplinary action may also be taken.
Marks will be allocated as follows:
Correct answer = 1 point
Wrong answer = 0 points4
Question 1:
Companies that use WACC as the required rate of return for all investment projects, regardless
of risk will tend to:
a) Incorrectly reject high risk projects.
b) Incorrectly accept low risk projects.
c) Decrease in risk and decrease in value over time.
d) Increase in risk and decrease in value over time.
Question 2:
You are analysing an investment project with conventional cash flows. The required rate of
return on the project is 12% and the IRR is 9%. The NPV of the project is:
a) Negative
b) Positive
c) Zero
d) Undetermined5
Question 3:
A manufacturing company is trying to decide between the following two mutually exclusive
projects:
Cash Flows
Year Project I Project II
0 -$12,000 -$18,000
1 $6,500 $8,500
2 $6,000 $9,000
3 $7,000 $9,500

The company requires that all accepted projects have a payback less than three years and
produce a minimum rate of return of 11%. What should the company do and why?
a) Project I should be accepted but Project II should be rejected because only Project I satisfies
the payback period requirement.
b) Both projects should be accepted because they have IRRs which exceed the 11% requirement.
c) Both projects should be accepted because they both have positive NPVs.
d) Project II should be accepted because it has an NPV of $3,909. Project I cannot also be
accepted.
Question 4:
A firm’s capital structure is currently all debt and common stock. The firm is worth $100M
today and would like to raise another $20M by issuing preference shares with a fixed $5 p.a.
dividend in perpetuity. The cost of equity is 10%, after-tax cost of debt is 7%, and the current
WACC is 8%. What should be the minimum price per preference share if the firm does not want
to raise its WACC?
a) $4.00
b) $50.00
c) $62.50
d) $71.436
Question 5:
The IRR on an investment project with conventional cash flows is 11.38%. Which of the
following (is) are true if the project is assigned a 9.5% required rate of return?
I. The project will have a negative net present value.
II. The initial investment is less than the market value of the project.
III. The project will have a positive effect on shareholders if it is accepted.
a) I only
b) I and II only
c) I and III only
d) III only
Question 6:
A company owns a building that is totally paid for. This building has been sitting idle for the past
three years. Now the company is trying to analyse a project that would include the use of this
building. Which of the following costs should be included in that analysis?
I. The property taxes paid on the building over the past three years
II. The insurance paid on the building over the past three years
III. The current market value of the building
IV. The cost to construct a drainage pond required for the project
a) I and II only
b) III and IV only
c) I, II and III only
d) I, II, and IV only7
Question 7:
The EAV method for evaluating projects applies when which of the following project
characteristics exist?
I. The projects are mutually exclusive.
II. The projects have different economic lives.
III. The projects will be replaced more or less indefinitely.
a) I or II only
b) I and III only
c) I and II and III
d) III only
Question 8:
Which of the following statements is (are) true concerning the internal rate of return (IRR)?
I. The IRR is the best technique to use for mutually exclusive investment projects.
II. The IRR method can produce multiple rates of return if the cash flows are
nonconventional (multiple sign changes).
III. The crossover point occurs where the IRR of two projects are equal.
a) II only
b) III only
c) II and III only
d) I and II only8
Question 9:
A company is considering two mutually-exclusive projects with the following projected after-tax
cash-flows (assume earnings and cash flows are the same):
Year Project A Project B
0 -$100,000 -$20,000
1 $90,000 $5,000
2 $10,000 $5,000
3 $10,000 $12,000
4 $45,000 $12,000
The required rate of return is 10% and the required ARR based on initial investment is 40%.
What should the company do according to the NPV and ARR methodologies?
a) Accept Project A according to both NPV and ARR.
b) Accept Project B according to both NPV and ARR.
c) Accept Project A according to NPV and project B according to ARR.
d) Accept Project B according to NPV and project A according to ARR.
Question 10:
Which of the following statements is true?
I. For independent projects, the ARR and NPV methodologies will always give consistent
decisions.
II. For independent projects, the payback period and NPV methodologies will always give
consistent decisions.
III. For mutually-exclusive projects, the ARR and NPV methodologies will always give
consistent decisions.
IV. For mutually-exclusive projects, the payback period and NPV methodologies will always
give consistent decisions.
a) I only
b) I and II only
c) II, II and IV only
d) None9
Question 11:
Which of the following statements about inflation and capital budgeting is true? Assume that
expected inflation is positive.
a) For a project with an initial outlay and positive future cash flows, using a real discount rate
with nominal cash flows will produce an incorrect NPV that is greater than the true NPV.
b) For a project with an initial outlay and positive future cash flows, using a nominal discount
rate with real cash flows will produce an incorrect NPV that is greater than the true NPV.
c) For a project with an initial outlay and positive future cash flows, using a real discount rate
with real cash flows will produce an incorrect NPV that is lower than the true NPV.
d) For a project with an initial outlay and positive future cash flows, using a nominal discount
rate with nominal cash flows will produce an incorrect NPV that is lower than the true NPV.
Question 12:
Assume that a firm is financed by 50 percent equity, 15 percent preference shares and the
remainder by debt. The corporate tax rate is 30 percent. The before-tax costs of capital for debt,
preference and equity capital are 8 percent, 10 percent and 14 percent, respectively. What is the
firm’s after-tax weighted average cost of capital? The firm is considering three independent
projects: projects A, B and C with IRRs of 8%, 10% and 12% respectively. These projects have
conventional cash flows and the same risk as the firm’s current operations. Which of these
projects should it accept?
a) Only project A
b) Only project C
c) Projects A and B
d) Projects B and C10
Question 13:
The initial cost of a machine required for a project is $50,000. It has a useful life of 8 years and
will be depreciated on a straight-line basis over 8 years. The machine is expected to generate
before-tax cash flows of $8,000 per year life and the effective corporate tax rate is 30%. The
appropriate discount rate is 12% p.a. after-tax. The company plans to sell the machine for
$10,000 at the end of year 6. Which of the following statements is true?
a) The project should be accepted because the NPV is $50,201.
b) The project should be rejected because the NPV is -$2,679.
c) Depreciation is irrelevant because it is not a cash flow.
d) The after-tax salvage value in year 6 is $10,750.
Question 14:
Which of the following statements about the net present value method of selecting projects is
true?
I. For two mutually exclusive projects with conventional cash flows, the net present value
and internal rate of return methods select different projects if the required rate of return is
greater than the discount rate at which the two net present value profiles intersect.
II. If a project's cash flows (including the investment) are positive after discounting them by
the required rate of return, then it may be accepted if there are no better alternatives.
III. If projects are independent, then the project with the highest net present value (providing
it is greater than zero) is acceptable.
IV. If the projects are mutually exclusive, then all projects with a net present value greater
than zero are accepted.
a) II only
b) III only
c) II and III only
d) I, and IV only11
Question 15:
The forecast net cash flows of two mutually exclusive projects, A and B, are shown in the
following table.
Year Project A Project B
0 - $55,000 - $35,000
1 $26,000 $25,100
2 $12,500 $16,900
3 $44,400 $17,500
4 $26,200 $11,600
5 $13,200 $8,250
The NPV and IRR methods must give conflicting ranks for these projects if:
a) The required rate of return is less than 25% pa.
b) The required rate of return is greater than 25% pa.
c) The required rate of return is between 35% pa and 45% pa.
d) None of the above.
Question 16:
The forecast net cash flows of two mutually exclusive projects, J and K, are shown in the
following table.
Year (end) Project A Project B
0 - $225,000 - $150,000
1 $67,000 $75,000
2 $89,400 $81,300
3 $81,100 $25,500
4 $45,700 $14,400
Which one of the following four statements about these projects is correct?
a) NPV and IRR must give conflicting ranks if the required rate of return is less than 10.4% pa.
b) Both projects should be rejected if the required rate of return is greater than 15.8% pa.
c) If the required rate of return is 5% pa, Project A should be accepted.
d) If the projects had not been mutually exclusive, both would be acceptable if the required rate
of return was less than 15.7% pa.