Seminar 7.

Foundations of Finance MN1019

Academic year 2016-2017

1. A new project is expected to produce the following cash flows: −£15, 000
in year 0, £8, 000 in year 1, £7, 000 in year 2, £5, 000 in year 3.
Required:
(i) Find the payback period (PP) of the project.
(ii) If the discount rate is 9%, what is the net present value (NPV) of
the project?
(iii) Suppose we calculate the internal rate of return (IRR) of the
project and we find IRR = 17.32%. Should we accept the project,
according to the IRR rule?
(iv) If the discount rate is 9%, what is the profitability index (PI) of
the project?
(v) What can we conclude from (ii), (iii) and (iv)?

2. The financial management division of a company ABC expects that

the return on the shares of ABC will depend on the performance of the
global economy, according to the following scheme:
(a) Excellent economy (probability of occurrence 0.25): return 15%
(b) Good economy (probability of occurrence 0.30): return 12%
(c) Neutral economy (probability of occurrence 0.15): return 5%
(d) Slight recession economy (probability of occurrence 0.20): return
0%
(e) Full recession economy (probability of occurrence 0.10): return -4%.
Determine the expected return on the ABC shares.

3. Suppose that the return on the shares of a company A depends on the

market conditions as follows:
(a) Growth (probability 0.3): return 7.33%
(b) Normal (probability 0.6): return 4.1%

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 (c) Recession (probability 0.1): return -2%
Calculate expected return, variance and standard deviation of the re-
turn on the shares of company A.

4. The management of a company AAB thinks that the return on the

shares of AAB in the next year will depend on the global state of
economy. It is expected that the return will be as follows:
(a) if state 1 occurs (probability of occurrence 25%), the return is 3%;
(b) if state 2 occurs (probability of occurrence 10%), the return is 1.5%;
(c) if state 3 occurs (probability of occurrence 15%), the return is 1%;
(d) if state 4 occurs (probability of occurrence 20%), the return is -0.5%;
(e) if state 5 occurs (probability of occurrence 30%), the return is -2.5%.
Required.
(i) Expected value of the return on the shares of AAB.
(ii) Standard deviation of this return.
(iii) Suppose now that all states have the same probability of occur-
rence. What is the expected value of the return in this case?