Question

fully! couts Problem 7. A company is planning an increase in its headcount due to reorganization and expansion of the business. This plan requires a relocation from the previous office to the larger one for 10 years. Your administration department has picked up two different options with different conditions required by landlords: the initial cash flow is the security deposit that will be returned back in the end of the rental agreement (not reflected in the table below). The further cash flows represent rental payments. The discount rate usually applied for rental projects is 6%, however these two options bear higher risk and require a premium of 1%. Option/time 0 Option 1 Option 2 -100 -200 -50 -30 2 -50 -40 3 -50 -50 4 -50 -45 5 -50 -45 6 -50 -45 7 -50 -45 8 -50 -45 9 -50 -45 10 -50 -45 a) Please evaluate the two options clearly stating the assumptions you are using. (8 points) b) Describe the benefits of NPV compared to IRR. (4 points) Will it be possible to use IRR in this case? (3 points) c) NPV and IRR always give contradictory results, thus IRR should not be applied in any case. Comment on the statement. (5 points) d) Financial assets are different from real projects in their essence, thus valuation techniques should also be different. Comment on the statement. (5 points) Problem 8. A large pharmaceutical company with AAA rating is planning to raise funds for its new R&D project, a) Please describe the ways available for the company to get necessary financing, specifically

Answer 1

(a).

Discount rate = 6 + 1 = 7 %

Assume that this is compounded annually.

NPV of first option

= -100 -50x1.07^-1 -50x1.07^-2 -50x1.07^-3 -.............-50x1.07^-10 + 100x1.07^-10

=-100 - [50x1.07^-1x(1 - 1.07^-10) / (1 - 1.07^-1)] + 100x1.07^{-10 (Using formula for the sum of a GP)}

^{= - 400.344}

^{NPV of second option}

= -200 -30x1.07^-1 -40x1.07^-2 -50x1.07^-3 -45x1.07^-4 -45x1.07^-5-.........-45x1.07^-10 + 200x1.07^-10

= -200 -30x1.07^-1 -40x1.07^-2 -50x1.07^-3 - [45x1.07^-4x(1 - 1.07^-7) / (1 - 1.07^-1)] + 200x1.07^-10. (Using formula for the sum of a GP)

^{= -400.087}

^{The two NPVs are very close, with the second option having slightly greater value(slightly lower cost)}

^(b)

^{The NPV method models all cash flows of a project until completion and discounts these back to the present day using the cost of capital.}

IRR method is essentially the same in calculation as the NPV method, the difference being that rather than discounting at the cost of capital, a solution is found for the interest rate that gives the project a zero NPV.

Thus NPV method is simple to use and mathematically tractable

There are particular problems with the IRR method.

• Nonsense results can be obtained if the initial capital is small, giving very high positive(or negative) solutions, two solutions or no solution.
• While the average NPV of a range of scenarios can be found simply by summing the value multiplied by the probability of the scenario, this is not the case for the IRR.

It should be noted that the IRR equation can some times have multiple solutions, especially if there are net negative cash flows at some point during the operating life of the project or at the completion. This has helped to make it less popular than the NPV as a measure of project worth.

In the given problem both options involve negative cash flows followed by a single positive cash flow at the end of the term. Therefore the equation for IRR will have no positive real solution.

(c)

The statement is not true, as in most of the cases both the methods give identical results. However in some situations the two methods can give contradictory results, especially when there is a number of sign changes in the cash flows. IRR method can still be used in such situations if carefully and correctly applied.

In case of a typical project where there is an large initial capital outflow followed by a stream of running costs and revenues, both methods can be applied and will give identical results.