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# ECF5220 Principles of Finance

ECF5220 Principles of Finance – Final Exam 2/10

Note these are brief solutions only.  For theory questions a fuller coverage would be required in an exam

Question 1

Decision:     The NPV is positive so the project should be accepted.

Notes:

1.             The market research cost (\$20,000) is a sunk cost and should be omitted.

2.             A proportion of head office costs (\$10,000) are allocated overheads – not an incremental expense.

3.             Interest expense should be excluded as this cost is built into the discount rate used to derive the NPV. However, it is a relevant cash flow in deriving the payback period.

Question 2

(A) Pluto Ltd.

Mortgage loan:

PV = -\$500,000             n = 8x12             i = 9%/12

PMT = \$7,325.1016

PMT = \$7,325.1016    n =8x12              i = 8.4%/12

PV = \$510,786.51

Effective annual rate = (1 + 0.084/12)12 – 1 = 0.087311 or 8.7311%

After-tax cost = 8.7311% (1 - 0.3) = 6.1117%

Debentures:

PV = \$100.50       PMT = -8%x\$100/2                n = 5x2                FV = -\$100

i = 3.9385%

Effective annual rate = (1 + 0.039385)2 – 1 = 0.080321 or 8.0321%

After-tax cost = 8.0322% (1 – 0.3) = 5.6225%

MV = \$100.50 x 8,000 = \$804,000

Preference shares:

kp = (5% x 20)/21 = 4.7619%

MV = \$21 x 25,000 = \$525,000

Ordinary shares: -

ke = 0.40(1+ 0.03)/8 + 0.03 = 8.15%

MV = \$8.00 x 400,000 = \$3,200,000

 Cost of Capital Market value Proportion Cost After-tax Wt Cost Mortgage loan 510,787 0.1014 8.731% 6.1117% 0.6197% 8% Debentures 804,000 0.1595 8.032% 5.6225% 0.8968% 5% preference shares 525,000 0.1042 4.762% 0.4962% Ordinary shares 3,200,000 0.6349 8.150% 5.1744% 5,039,787 1.0000 7.1872%

Correct WACC = 7.19%

(B)        EOQ model determines the inventory level that minimises the total costs associated with inventory.

The model is based on the following assumptions:

Demand for the product per period is constant and known with certainty No quantity discounts are available

No lead time between ordering and receiving inventory

Explain each of the terms in the EOQ formula and the role of the model in minimising the total annual costs (i.e. acquisition costs + carrying

Standard Devaiation

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