Principles of Finance

HEC Lausanne Homework 2 October 08, 2019

Problem 1
a. The PV of the profits is P Vprof its = 1r (1 − 1
(1+r)10
)
0.1
The PV of the support costs is P Vsupport = r
NPV = -5 + P Vprof its + P Vsupport
r = 2% then NPV = $-1,017,414.99
r = 6% then NPV = $693,420.38
r = 12% then NPV = $-183,110.30
b. From the answer to part (a) there are 2 IRRs: 2.745784% and 10.879183% (You can solve
it quickly with excel, MATLAB or other programming tools or by hands perhaps.)
c. The IRR rule says nothing in this case because there are 2 IRRs, therefore the IRR rule
cannot be used to evaluate this investment

Problem 2
a.
2
N P Va = r
− 10, IRRa = 20%
1.5
N P Vb = r−0.02
− 10, IRRb = 17%
Based on the IRR, you always pick project A.
b.
Substituting r = 0.07 into the NPV formulas derived in part (a) gives:
N P Va = $18.5714 million,
N P Vb = $20 million.
So the NPV says take B.
c. Ranking the projects by their IRR is not valid in this situation because the projects have
different scale and different pattern of cash flows over time.
d.
Let N P Va = N P Vb , to get r = 0.08. So the IRR rule will give the correct answer for discount
rates greater than 8%.
e. They have the same scale, and the same timing (10-year annuities). Thus, as long as
they have the same risk (and therefore, cost of capital), we can compare them based on their
IRRs.

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 Principles of Finance
HEC Lausanne Homework 2 October 08, 2019

Problem 3

Problem 4
a. No, this is a sunk cost and will not be included directly. (But see (f) below.)
b. Yes, this is a cost of opening the new store.
c. Yes, this loss of sales at the existing store should be deducted from the sales at the new
store to determine the incremental increase in sales that opening the new store will generate
for HBS.
d. No, this is a sunk cost.
e. This is a capital expenditure associated with opening the new store. These costs will,
therefore, increase HBSs depreciation expenses.
f. Yes, this is an opportunity cost of opening the new store. (By opening the new store, HBS
forgoes the after-tax proceeds it could have earned by selling the property. This loss is equal
to the sale price less the taxes owed on the capital gain from the sale, which is the difference
between the sale price and the book value of the property. The book value equals the initial
cost of the property less accumulated depreciation.)
g. While these financing costs will affect HBSs actual earnings, for capital budgeting purposes
we calculate the incremental earnings without including financing costs to determine the
projects unlevered net income.

Problem 5
F CF = EBIT (1 − t) + depreciation − CAP X − change in NWC

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 Principles of Finance
HEC Lausanne Homework 2 October 08, 2019

FCF from outside supplier = -$2*300,000 * (1 - 0.35) = -$390k per year.

1 1
N P Voutside = −390000 ∗ 0.15
∗ (1 − 1.1510
) = −1.9573M
FCF in house: in year 0: - 250 CAPX - 50 NWC= - 300K
FCF in years 1-9:

FCF in year 10:

−$283, 750 + (1 − 0.35) ∗ $20, 000 + $50, 000 = −$220, 750F CF
Note that the book value of the machinery is zero; hence, its scrap proceeds ($20,000) are
fully taxed.
The NWC ($50,000) is recovered at book value and hence not taxed.
−220,750
NPV (in house): -$300k+ annuity of -$283,750 for 9 years+ 1.1510
= -$1.7085M
Thus, in-house is cheaper, with a cost savings of ($1.9573M - $1.7085M) = $248.8K in present
value terms.