CF 0708 Ex Resolution

International MSc in Business Administration
Corporate Finance 07 A
Guilherme Almeida e Brito, Mário Meira
Required reading: Portfolio Theory: BMA: Chap. 7, 8 (9th edition: 8, 9).
Exercises to be prepared for November 20th: Iceberg, Innovation, NewDesign.
Exercises to be prepared for November 20th: Ross, Westerfield & Jaffe: 6.1, 6.9;
Exercises to be prepared for November 21th: Ibbotson, Macrasoft, Portfolio Theory;
Mandatory exercise to be handed in on November 22nd before 6:30pm: FunRide (instead of NewDesign).

Ross, Westerfield & Jaffe: 6.1 (adapted)
Fuji Software, Inc., has the following projects:
Year Project A Project B
0
-$7.500
-$5.000
1
4.000
2.500
2
3.500
1.200
3
1.500
3.000
Suppose you have determined that the appropriate discount rate for these projects is 15%.
a. Suppose Fuji’s cutoff payback period is two years. Which of these two projects should be chosen?
b. Estimate the discounted payback period for the two projects.
c. Suppose Fuji uses the NPV rule to rank these two projects. Which project should be chosen?
Ross, Westerfield & Jaffe: 6.9 (adapted)
As the treasurer of London Express, you are offered the following two mutually exclusive projects:
Year Project A Project B
0
-$5.000
-$100.000
1
3.500
65.000
2
3.500
65.000
Suppose you have determined that the appropriate discount rate for these projects is 15%.
a.
b.
c.
d.
e.

What are the IRRs of these two projects?
If you are told only the IRRs of the projects, which would you choose?
What did you ignore when you made your choice in part b)?
How can the problem be remedied?
Compute the incremental IRR for the projects.

f. Based on your answer to part e), which project should you choose?
g. According to the NPV rule, which of these two projects should be adopted?

Ibbotson (adapated from Ross, Westerfield and Jaffe)
Ibbotson and Sinquefield have reported the returns on small-company stocks in the U.S. Treasury bonds for the period 1986-1991 as follows.
Year
1986
1987
1988
1989
1990
1991