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1. FIN 515 Week 3 Problem Set
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Chapter 7 (pages 225-228):
1. Your brother wants to borrow $10,000 from
you. He has offered to pay you back $12,000 in
a year. If the cost of capital of this investment
opportunity is 10%, what is its NPV? Should
you undertake the investment opportunity?
Calculate the IRR and use it to determine the
maximum deviation allowable

2. in the cost of capital estimate to leave the
decision unchanged.
8. You are considering an investment in a
clothes distributor. The company needs
$100,000 today and expects to repay you
$120,000 in a year from now. What is the IRR
Wof this investment o
pportunit
y? Given the
riskiness of the
investment opportunity, your
cost of capital is 20%. What does the IRR rule
say about whether you should invest?
19. You are a real estate agent thinking of
placing a sign advertising your services at a
local bus stop. The sign will cost $5,000 and

3. will be posted for one year. You expect that it
will generate additional revenue of $500 per
month. What is the payback period?
21. You are deciding between two mutually
exclusive investment opportunities. Both
require the same initial investment of $10 million
.
Investment A w
m generate
$2 million
per year (starting at
the end of the first year) in perpetuity.
Investment B will generate $1.5 million at the
end of the first year and its revenues will grow
at 2% per year for every
year after that.
a. Which investment has the higher IRR?

4. b. Which investment has the higher NPV when
the cost of capital is 7%?
c. In this case, for what values of the cost of
capital does picking the higher IRR
give the correct answer as to which
investment is the
best opportunity?
Chapter 8 (260-262)
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1. Pisa Pizza, a seller of frozen pizza, is
considering introducing a healthier version of
its pizza that will be low in cholesterol and
contain no trans fats. The firm expects that sales
of the new pizza will be $20 million per year.
While many of these sales will be to new
customers, Pisa Pizza estimates that 40% will
come from customers who switch to the new,

5. healthier pizza instead of buying the original
version.
a. Assume customers will spend the same
amount on either version. What level of
incremental sales is associated with introducing
the new pizza?
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b. Suppose that 50% of the customers who will
switch from Pisa Pizza's original pizza to its
healthier pizza will switch to another brand if
Pisa Pizza does not introduce a healthier pizza.
What level of incremental sales is associated
with introducing the new
pizza in this case?

6. 6. Cellular Access, Inc. is a cellular telephone
service provider that reported net income of
$250 million for the most recent fiscal year.
The firm had depreciation expenses of $100
million, capital expenditures of $200 million,
and no interest expenses. Working capital
eased by $10 millio
sh flow for Cellular Acce
la ree
or
recent fiscal year.
12. A bicycle manufacturer currently produces
300,000 units a year and expects output levels
to remain steady in the future. It buys chains
from an outside supplier at a

7. price of $2 a chain. The plant manager believes
that it would be cheaper to make these chains
rather than buy them. Direct inhouse
production costs are estimated to be only $1.50
per chain. The necessary machinery would cost
$250,000 and would be obsolete after 10 years.
This investment could be depreciated to zero
for tax purposes using a 10-year straight-line
depreciation schedule.
The plant manager estimates that the operation
would require $50,000 of inventory and other
working capital upfront (year 0), but argues
that this sum can be ignored because it is
recoverable at the end of the 10 years. Expected
proceeds from scrapping the machinery after 10
years are $20,000.

8. If the company pays tax at a rate of 35% and the
opportunity cost of capital is 15%, what is the
net present value of the decision to produce the
chains in-house instead of purchasing them
from the supplier?
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