Question
1. You are considering investing in a start-up company.The founder asked you for $200,000 today and youexpect to get $1,000,000 in nine years. Given theriskiness
1. You are considering investing in a start-up company.The founder asked you for $200,000 today and youexpect to get $1,000,000 in nine years. Given theriskiness of the investment opportunity, your cost ofcapital is 20%. What is the NPV of the investmentopportunity? Should you undertake the investmentopportunity? Calculate the IRR and use it todetermine the maximum deviation allowable in thecost of capital estimate to leave the decisionunchanged.
2. Bill Clinton reportedly was paid $15 million towrite his book My Life. Suppose the book took threeyears to write. In the time he spent writing, Clintoncould have been paid to make speeches. Given hispopularity, assume that he could earn $8 million peryear (paid at the end of the year) speaking instead ofwriting.
Assume his cost of capital is 10% per year.
a. What is the NPV of agreeing to write the book(ignoring any royalty payments)?b. Assume that, once the book is finished, it is expectedto generate royalties of $5 million in the first year(paid at the end of the year) and these royalties areexpected to decrease at a rate of 30% per year inperpetuity. What is the NPV of the book with theroyalty payments?
3. OpenSeas, Inc. is evaluating the purchase of a newcruise ship. The ship would cost $500 million, andwould operate for 20 years. OpenSeas expects annualcash flows from operating the ship to be $70 million(at the end of each year) and its cost of capital is12%.
a. Prepare an NPV profile of the purchase.b. Estimate the IRR (to the nearest 1%) from thegraph.c. Is the purchase attractive based on these estimates?d. How far off could OpenSeas' cost of capital be (tothe nearest 1%) before your purchase decisionwould change?
4. You own a coal mining company and areconsidering opening a new mine. The mine itself willcost $120 million to open. If this money is spentimmediately, the mine will generate $20 million forthe next 10 years. After that, the coal will run out andthe site must be cleaned and maintained atenvironmental standards. The cleaning andmaintenance are expected to cost $2 million per yearin perpetuity. What does the IRR
rule say about whether you should accept thisopportunity? If the cost of capital is 8%, what doesthe NPV
rule say?
5. You are considering making a movie. The movie isexpected to cost $10 million upfront and take a yearto make. After that, it is expected to make $5 millionwhen it is released in one year and $2 million per yearfor the following four years. What is the paybackperiod of this investment? If you require a paybackperiod of two years, will you make the movie? Doesthe movie have a positive NPV if the cost of capital is10%?
6. You are deciding between two mutually exclusiveinvestment opportunities. Both require the sameinitial investment of $10 million. Investment A willgenerate $2 million per year (starting at the end ofthe first year) in perpetuity. Investment B willgenerate $1.5 million at the end of the first year andits revenues will grow at 2% per year for every yearafter that.
a. Which investment has the higher IRR?b. Which investment has the higher NPV when the costof capital is 7%?c. In this case, for what values of the cost of capitaldoes picking the higher IRR give the correctanswer as to which investment is the bestopportunity?
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