Financial Risk Management

Module 3 Investment evaluation and capital structure

Question 1
GBC Ltd is considering a project with an initial cost of $10 000 and zero salvage value. The project will last for
four years and it is estimated that the net annual cash flows in real terms will be $4000. The nominal discount rate
is 8per cent per annum and the inflation rate over this period is expected to be 3 per cent per annum. Assuming
no tax effects or depreciation, this projects net present value(NPV) can be calculated by which of the following
method(s)?
I. Discount $4000 over four years at 4.85 per cent, and subtract $10 000.
II. Discount the following annual cash flows at 8 per cent: $4120 (year 1), $4244 (year 2), $4371 (year 3) and
$4502 (year4) and subtract $10 000.
III. Discount $4000 over four years at 8 per cent and subtract $10 000.
IV. Discount the following annual cash flows at 4.85 per cent: $4120 (year 1), $4244 (year 2), $4371 (year 3)
and $4502 (year 4) and subtract $10 000.
a. I and II only.
b. I and IV only.
c. II and III only.
d. III and IV only.
Question 2
Which one of the following statements about the internal rate of return (IRR) method of project evaluation
iscorrect?
a. The IRR discounts the forecasted net cash flows at the opportunity cost of funds.
b. The IRR considers the timing and magnitude of cash flows.
c. There is always one unique IRR associated with a project.
d. The IRR leads to the project that maximises the wealth of shareholders.
Question 3
ARN Ltd is considering the following mutually exclusive projects.
Which one of the following statements is correct?
a. Project B should be undertaken because NPV
B
> NPV
A
and IRR
B
> IRR
A
.

b. Both projects should be accepted because their NPVs are positive.
c. Project A should be undertaken because EAA
A
> EAA
B
.
d. Project B should be undertaken because IRR
B
> IRR
A
.
Year 0 Year 1 Year 2 Year 3 NPV at 12% IRR EAA
Project A $1000 $700 $800 $263 31% $156
Project B $750 $300 $500 $600 $344 34% $143
Module 3 Investment evaluation and capital structure (FRM)
Semester 2, 2013 Page 1
Question 4
PLC Ltd has evaluated two projects which have the following internal rates of return (IRRs) and net present
values (NPVs).
If the company used the same discount rate to evaluate the above projects, what can be said about the
discountrate?
a. It is below 10 per cent.
b. It is between 10 per cent and 14 per cent.
c. It is equal to 14 per cent.
d. It is above 14 per cent.
Question 5
If a company undertakes a project whose net present value (NPV) is zero, which one of the following statements
iscorrect?
a. The market value of its debt will fall while the value of its equity will rise.
b. The market value of its debt will rise while the value of its equity will fall.
c. The market value of its equity will rise.
d. The total value of the company will remain unchanged.
Question 6
Which one of the following statements about the discount rate used to evaluate projects is correct?
a. It will usually differ from the companys weighted average cost of capital.
b. It discounts current cash flows more highly than future cash flows.
c. It is inconsistent with the capital asset pricing model (CAPM).
d. It combines adjustments for risk and time.
Question 7
Which one of the following statements about the required return on an investment project is correct?
a. It is the marginal cost of a new investment.
b. It is the coupon rate on debt.
c. It is the rate of return required by the companys owners.
d. It is the minimum rate that must be earned on the project.
Question 8
Assume a company has the opportunity to undertake a new project. The required return on equity, assuming it
were all equity financed, is20 per cent. Ignoring any tax effects, what would be the required return on equity if
25 per cent of the required finance were obtained through a bank loan costing 14 per cent?
Project X Project Y
IRR 10.0% 14.0%
NPV $100 000 $450 000
Module 3 Investment evaluation and capital structure (FRM)
Semester 2, 2013 Page 2
a. 14 per cent.
b. 20 per cent.
c. Greater than 14 per cent and less than 20 per cent.
d. Greater than 20 per cent.
Question 9
If the risk-free rate is 5 per cent, the expected return on a market portfolio is 10 per cent and the companys
equity beta is estimated at 2.0, what is the required return on equity?
a. 5 per cent.
b. 10 per cent.
c. 15 per cent.
d. 20 per cent.
Question 10
What does an equity beta of 0.9 imply about the risk of a companys equity?
a. Systematic risk is greater than that of the market portfolio.
b. Systematic risk is less than that of the market portfolio.
c. Unsystematic risk is less than that of the market portfolio.
d. Unsystematic risk is greater than that of the market portfolio.
Question 11
The variability of which one of the following items indicates the existence of business risk?
a. Operating income.
b. Return on equity.
c. Debt-to-equity ratio.
d. Net income.
Question 12
All else being the same, which one of the following factors would be most likely to stimulate investment in
newprojects?
a. An increase in personal tax rates.
b. The introduction of a capital gains tax.
c. An increase in the inflation rate.
d. A decrease in the risk-free rate.
Question 13
Select the alternative which accurately evaluates the following statement: We do all our capital budgeting in
real terms. This avoids the need to estimate the inflationrate.

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a. Correct, since the effect on cash flows is offset by a corresponding adjustment to the discount rate.
b. Correct, since inflation rate adjustments are factored into the discount rate.
c. Correct, since the cash flow estimates of the project should always be expressed in real terms.
d. Incorrect, since inflation rate estimates are needed because depreciation tax shields are based on
historical costs rather than replacement costs.
Question 14
Which one of the following statements concerning interest tax shields is not correct?
a. They should be completely ignored since they are a financing cash flow, not a project cash flow.
b. They have no value if the company does not pay company tax.
c. They can be treated as side effects in the adjusted present value (APV) approach.
d. They are implicitly included through the calculation of the weighted average cost of capital in the net
present value (NPV)method.
Question 15
Ejection Systems Ltd is considering the following investment project.
What is the net present value (NPV) of the project, assuming no tax effects or depreciation?
a. +$62 600.
b. +$66 284.
c. +$124 664.
d. +$350 000.
Question 16
HiTech Ltd has to choose between two alternative machines, X and Y, which perform the same function but
have lives of one and three years, respectively. The initial cost of Machine X is $25 000 and its annual operating
costs are expected to be $4000. The initial cost of Machine Y is $50 000 and its annual operating costs are
expected to be $10000. Assume that the projects are repeatable and there are no constraints on the availability
of funds. If HiTechs cost of capital is 12 per cent per annum, what are the net present values (NPVs) of costs
that should be used in comparing the twomachines? (Use the lowest common duration method to calculate
theanswer.)
Initial cost $450 000
Salvage value $0
Useful life 8 years
Annual real net cash flow $100 000
Nominal discount rate 20 per cent p.a.
Expected inflation rate 8 per cent p.a.
Machine X Machine Y
Combination I $28 571 $58 929
Combination II $28 571 $74 018
Combination III $51 348 $74 018
Combination IV $76 859 $74 018
Module 3 Investment evaluation and capital structure (FRM)
Semester 2, 2013 Page 4
a. Combination I.
b. Combination II.
c. Combination III.
d. Combination IV.
The following case note relates to the next two (2) questions (questions 17 to 18)
ZYX Ltd is a manufacturer of personal computer components and is considering implementing a proprietary
technology in the manufacturing process of its next generation of hard drives. It expects that this technology
will be prohibitively expensive for its competitors to copy. As a result, it expects the project to generate net
after-tax cash flows of $230 000 next year, with the cash flows expected to grow at a constant rate of 4 per cent
per annum forever. The initial investment required for this project is $2 million. The company has decided to use
a discount rate of 14 per cent to evaluate theproject.
Question 17
The projects net present value (NPV) is closest to
a. $357 143.
b. $291 429.
c. +$300 000.
d. +$392 000.
Question 18
The projects internal rate of return (IRR) is closest to
a. 4 per cent.
b. 7.5 per cent.
c. 11.5 per cent.
d. 15.5 per cent.
The following case note relates to the next two (2) questions (questions 19 to 20)
E-Made Ltd is an Australian company that manufactures and distributes computers throughout Asia and
Australia. Theboard of E-Made Ltd is considering an expansion of its current activities and has employed you
as a consultant. Youhave obtained the following financial information.
Liabilities
Equity

Trade creditors $4 200 000

Provision for long service leave 97 000
Bonds 5 400 000
P & L appropriation $380 000
Ordinary shares 1 300 000
General reserve 930 000
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Other information
I E-Made Ltd pays interest on its bonds of $386 100 at the end of each year. The bonds mature in seven
years. Thecurrent market interest rate on bonds of equivalent amount and maturity is 6.5 per cent
perannum.
I 1 300 000 ordinary shares issued, last traded at $2.
I Company tax rate is 30 per cent.
I The cost of equity has been estimated at 13 per cent.
Question 19
What is the after-tax weighted average cost of capital (WACC) for E-Made Ltd?
a. 4.12 per cent.
b. 7.23 per cent.
c. 8.56 per cent.
d. 10.32 per cent.
Question 20
Which one of the following statements is correct?
a. If we had ignored the tax effects on the debt, there would be no difference between the calculated
WACC and the correctWACC.
b. If we had ignored the tax effects and the book values of debt and equity were used, the resulting WACC
would be lower than the correctly calculatedWACC.
c. If we had ignored the tax effects on the debt, the resulting WACC would be higher than the WACC
incorporating taxeffects.
d. If the book values for debt and equity were used, there would be no difference between the calculated
WACC and the correct WACC because the weights would be thesame.





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Solutions
Question 1
Correct Answer: a
Item I is correct because it discounts the real annual cash flows of $4000 at the real discount rate. Note that the
real discount rate can be calculated using the Fisher equation as: (1 + 0.08)/(1 + 0.03) 1 = 0.0485.
Item II is also correct because it discounts nominal cash flows at the nominal discount rate. The nominal cash
flows are obtained as
Year 1: 4000 1.03 = 4120;
Year 2: 4000 1.032 = 4244;
Year 3: 4000 1.033 = 4371; and
Year 4: 4000 1.034 = 4502.
To obtain the NPV, we discount these nominal cash flows at the nominal discount rate of 8 per cent.
Both methods will give the same answer because the two methods treat cash flows consistently. That is,
wediscount real cash flows at the real discount rate and nominal cash flows at the nominal discount rate.
Item III is incorrect because it discounts real cash flows at the nominal discount rate.
Item IV is incorrect because it discounts nominal cash flows at the real discount rate.
You can review this topic area in the study materials under the sections entitled Net present value and
Inflation and capital budgeting.
Question 2
Correct Answer: b
The calculation of the IRR takes into consideration the timing and size of the cash flows of a project.
Option A is incorrect because the IRR is the rate of return that equates the projects net present value (NPV) to
zero and does not reflect the projects opportunity cost.
Option C is incorrect because projects whose cash flows change sign in the future can have multiple IRRs.
Option D is incorrect because the IRR does not necessarily lead to the selection of the project with the maximum
NPV project, and hence its use may not lead to a maximisation of shareholder wealth.
You can review this topic area in the study materials under the sections entitled Internal rate of return and
NPV and IRR methods compared.
Question 3
Correct Answer: c
Projects with different lives should be compared on the basis of standardised time horizons. This can be
achieved with either the equivalent annual annuities (EAAs), or the net present value (NPV) with continuous
replacement. Note that the latter is not calculated in this question since the relative rankings would not change.

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Option A is incorrect because the NPVs are not based on the same project lives. Also, internal rates of return
(IRRs) are not a reliable basis of comparison.
Option B is incorrect because the projects are mutually exclusive so only one project can be chosen.
Option D is incorrect because of the deficiencies of the IRR discussed in the module.
You can review this topic area in the study materials under the section entitled Mutually exclusive projects with
different lives.
Question 4
Correct Answer: b
This question has provided two sets of related information (i.e. IRR and NPV) and is asking you to determine
what the discount rate is likely to be. In this way, the question is asking you to reverse engineer the answer.
For Project X, when the IRR is 10 per cent the NPV is zero. This means that if the discount rate is higher than
10per cent, the NPV is going to be less than zero. We then see that the NPV is $100000. As such, we know
that the discount rate is going to be higher than 10 per cent.
For Project Y, when the IRR is 14 per cent the NPV is zero. This means that if the discount rate is lower than
14per cent, the NPV is going to be greater than zero. We then see that the NPV is $450000. As such, we know
that the discount rate is going to be lower than 10 per cent.
Because the company uses the same discount rate to evaluate both projects, we know that it must therefore
besomewhere between 10 and 14 per cent.
You can review this topic area in the study materials under the section entitled NPV and IRR methods
compared.
Question 5
Correct Answer: d
A zero NPV project is one which generates sufficient cash to service the funds (both debt and equity) invested
with no surplus left over. So, such a project will leave the market value of the company unchanged.
You can review this topic area in the study materials under the section entitled Net present value.
Question 6
Correct Answer: d
The discount rate combines adjustments for risk and time. It does the former by adding a riskpremium to the
risk-free rate. It does the latter by penalising distant cash flows more heavily than current cashflows.
Option A is incorrect because there is no reason to believe that a projects discount rate will not be the same as
the companys cost of capital. This will only be the case when the project being undertaken substantially alters
the companys business and/or financial risk. In such cases a project-specific discount rate will need to be used
to evaluate that project.

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Option B is incorrect because the opposite is the case (i.e. distant cash flows are penalised rather than current
cash flows).
Option C is incorrect because the discount rate is typically obtained using the CAPM.
You can review this topic area in the study materials under the section entitled Quantitative factors.
Question 7
Correct Answer: d
The required rate of return is the minimum rate that must be earned on an investment project. That is, it is the
hurdle rate used to evaluate a project. If the projects internal rate of return exceeds this hurdle rate the project
will have a positive NPV and, from a financial perspective, it should be accepted because it adds value to the
company. Conversely, if the internal rate of return lies below this hurdle rate the project will have a negative NPV
and, from a financial perspective, it should be rejected.
Note that Option C is incorrect as the required rate of return can be a weighted average for the cost of both
equity and debt, or possibly based on the cost of debt for a debt-funded project.
You can review this topic area in the study materials under the section entitled Quantitative factors.
Question 8
Correct Answer: d
The effect of introducing debt finance is to increase the risk to equity holders because the company has to pay
interest and principal to debt holders before any profits are available for distribution as dividends to equity
holders. As a result, equity holders require a higher return on equity compared to a situation with no debt.
So,the required return on equity must increase above the all-equity rate of 20 per cent.
You can review this topic area in the study materials under the section entitled Quantitative factors.
Question 9
Correct Answer: c
From the capital asset pricing model (CAPM), we have: E(r) = r
f
+ [E(r
m
) r
f
].

So, E(r) = 5.0 + [10.0 5.0]2.0 = 15.0%.
You can review this topic area in the study materials under the section entitled Quantitative factors.
Question 10
Correct Answer: b
Beta is a measure of the systematic (or market) risk associated with a companys equity. Since the market
portfolios beta is 1.0, a beta less than 1.0 means that the companys systematic risk is less than that of the
overall market.
You can review this topic area in the study materials under the section entitled Quantitative factors.

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Question 11
Correct Answer: a
Business risk is the risk inherent in a companys investment projects, that is, the risk in its business activities
independently of how those activities are financed.This risk is reflected in variability in the operating income
(i.e.earnings before interest and tax).
Options B, C and D are incorrect because they include aspects of financial risk, that is, the interest payments
ondebt.
You can review this topic area in the study materials under the section entitled Value, time and risk.
Question 12
Correct Answer: d
A decrease in the risk-free rate lowers the required return on funds invested and increases the present value of
available investment opportunities.
Options A and B are incorrect as these measures would tend to reduce the volume of funds available for
investment.
Option C is incorrect because an increase in the rate of inflation would raise the required return on investment
projects (as per the Fisher effect), and thus decrease their present value. However, the higher inflation rate
would also increase the nominal cash flows from projects and so the overall effect is uncertain.
You can review this topic area in the study materials under the section entitled Quantitative factors.
Question 13
Correct Answer: d
The statement is incorrect because capital budgeting in real terms does not avoid the need to estimate the
expected inflation rate. This estimate is needed to convert observed market rates (i.e. nominal rates) to real
discount rates. Itisalso needed to adjust depreciation tax shields, which are in nominal terms, to real tax shields.
You can review this topic area in the study materials under the section entitled Inflation and capital budgeting.
Question 14
Correct Answer: a
Interest tax shields (the reduction in tax paid by a company due to the tax deductibility of interest payments
ondebt finance) should be considered in the analysis. So the statement in option A is incorrect while the
statements in options B, C and D are all correct.
You can review this topic area in the study materials under the section entitled Estimating cash flows.

Module 3 Investment evaluation and capital structure (FRM)

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Question 15
Correct Answer: a
Option A is correct. First, the nominal rate of return is converted to a real rate of return. The next step is to apply
the NPV formula, making sure to discount the real cash flows with the real discount rate. Thus
Real discount rate = (1 + 0.2)/(1 + 0.08) 1 = 0.1111 or 11.11%.
So, NPV =[100 000 (1 (1 + 0.1111)
8
)/0.1111] 450 000 = $62 600.

Note that we could also convert the real cash flows to nominal cash flows and then apply the nominal discount
rate to compute the NPV. This method would give us the same NPV as above but (in this case) would require
more computations as each cash flow would need to be converted to a nominal cash flow and discounted
separately.
Option B is incorrect because the nominal discount rate is used to discount real cash flows.
Option C is incorrect because the inflation rate is used to discount the cash flows.
Option D is incorrect because the cash flows are not discounted.
You can review this topic area in the study materials under the section entitled Inflation and capital budgeting.
Question 16
Correct Answer: d
Using the common terminal date of three years, we would invest in Project X three times and Project Y once.
Since the initial and operating costs of the two machines are given, we can compute the net cash flows and
NPVs of costs as follows.
Note that in year 1 Machine X has an operating cost of $4000 and the second investment in Machine X costs
$25 000. Similarly, in year 2 Machine X has an operating cost of $4000 and the third investment in Machine X
costs $25 000. Then, in year 3, Machine X has the final operating cost of $4000. An alternative way of showing
the calculations for Machine X is as follows.
Year Cash flowsMachine
X and its replications
PV of cash flows
(k=12%)
Cash flowsMachine
Y
PV of cash flows
(k=12%)
0 $25 000 $25 000 $50 000 $50 000
1 $25 000 $4 000 $25 893 $10 000 $8 928
2 $25 000 $4 000 $23 119 $10 000 $7 972
3 $4 000 $2 847 $10 000 $7 118
NPV $76 859 $74 018
Year 0 1 2 3
Investment outflow $25 000 $25 000 $25 000
Operating outflow $4 000 $4 000 $4 000
Total outflow $25 000 $29 000 $29 000 $4 000
Discount factor (k = 12%) 1.0000 1.1200 1.2544 1.4049
Present value $25 000 $25 893 $23 119 $2847
Net present value $76 859
Module 3 Investment evaluation and capital structure (FRM)
Semester 2, 2013 Page 11
Based on this analysis, Machine Y would be preferred as it has the lower NPV of associated costs.
You can review this topic area in the study materials under the section entitled Mutually exclusive projects with
different lives.
Question 17
Correct Answer: c
As the cash flows from this project are expected to be $230 000 next year then grow at a constant rate of
4percent per annum forever, we have a growing perpetuity. As shown in Appendix 3.1, the present value of a
growing perpetuity can be computed as
PV = A(1 + g)/(k g).
Note that as the net inflows for Year 1 are $230 000, this is the value we use for the numerator.
A(1 + g) = 230 000.
g = 4% p.a.
PV = 230 000/(k 0.04).
So, given an initial investment of $2 000 000, the net present value of the project can be obtained as
NPV = 230 000/(k 0.04) 2 000 000.
Using a discount rate of 14 per cent we get the NPV as
NPV = 230 000/(0.14 0.04) 2 000 000 = $300 000.
You can review this topic area in the study materials under the sections entitled Net present value and
Presentvalue of a growing perpetuity (Appendix 3.1).
Question 18
Correct Answer: d
The IRR of a project is defined as the rate of return that makes the NPV of the project equal to zero. We know
that if the NPV is positive, then the IRR will be higher than the discount rate. The only option higher than the
discount rate is $15.5 per cent. Further, we can compute the IRR by setting the NPV equal to zero, as follows.
NPV = 0 = 230 000/(IRR 0.04) 2 000 000
Solving for IRR, we get:
2 000 000 = 230 000/(IRR 0.04)
2 000 000 (IRR 0.04) = 230 000
(IRR 0.04) = 230 000/2 000 000
IRR = 0.115 + 0.04
IRR = 0.155 or 15.5%.
You can review this topic area in the study materials under the section entitled Internal rate of return.
Module 3 Investment evaluation and capital structure (FRM)
Semester 2, 2013 Page 12
Question 19
Correct Answer: b
Option B is correct. It is computed using the WACC formula with taxes. It is necessary to compute the market
value of outstanding shares and the market value of outstanding bonds and convert the cost of bonds into
after-tax terms. Thecomputations are asfollows.
Costs of financing instruments
Market values of financing instruments
Proportions of financing instruments
Note that, in the above calculations, we have converted the interest (k
d
) to become after-tax. But we dont need
to adjust the cost of equity (k
e
) as this is provided on an after-tax basis (unless otherwise stated).
You can review this topic area in the study materials under the sections entitled Weighted average cost of
capital and WACC with taxes.
Question 20
Correct Answer: c
Incorporating tax effects reduces the cost of debt. So, ignoring tax effects will increase the WACC.
Option A is incorrect because ignoring tax effects will increase the WACC.
Option B is incorrect because using book value weights increases the WACC (in this example). Also, ignoring
tax effects will increase theWACC.
Option D is incorrect because the weights using book values are not the same as the weights using
marketvalues.
You can review this topic area in the study materials under the sections entitled Weighted average cost of
capital and WACC with taxes.
Bonds 6.5% (givenwe use the comparable market interest rate for the cost of bonds, not the
coupon rate)
Equity 13.0% (given)
Bonds
386 100 [1 (1.065)
7
]/0.065 + 5 400 000 /(1.065)
7

= 5 592 507
Equity 1 300 000 2.00 = 2 600 000
Total 8 192 507
Bonds 5 592 507/8 192 507 = 0.683
Equity 2 600 000/8 192 507 = 0.317
WACC = w
d
k
d
(1 ) + w
e
k
e
= 0.683 0.065 (1 0.30) + 0.317 0.130
= 7.23%.
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Semester 2, 2013 Page 13