Problem 5. The Costa Coffee Company (For short Costa) is anticipating a major expansion of its franchised coffee outlets into Europe and African countries. The investment opportunities available to the company involve rates of return and initial investment amounts that differ because of differences in operating costs and consumer demand in the countries involved. The total investment (Z) that Costa can undertake is constrained by the cost of capital (K), which is defined by the following function:

K = 6 + 0.8 Z

The initial investment and rate of return (or the IRR) for each country are listed below in order of decreasing rate of return.

Country

Initial Investment (Z)

($ millions)

Rate of Return (IRR) (%)

South Africa

3.8

16.0

Kenya

1.3

15.0

France

2.4

13.0

Germany

3.1

11.0

Ethiopia

1.9

9.0

(A) Plot the investment marginal cost of capital (MCC or WACC, we also call it the supply curve) and the investment demand curve (or the IRR curve) on the graph below. (Hint: note that you have to cumulate the values of Z on the horizontal axis).

(B)Determine the optimal level of investment and the corresponding cost of capital for the firm.

Problem 6: Johnny Walker, the general manager of the Eastern Tool Company, is considering introducing some new tools to the company's product line. The top management of the firm has identified three types of tools (referred to as projects A, B and C). The various divisions of the firm have provided the data given in the following table on these three possible projects. The company has a limited capital budget of $2.4 million for the coming year.

Project A

Project B

Project C

Present value of net cash flows

$3,000,000

$1,750,000

$1,400,000

Initial cost of the project

2,400,000

1,300,000

1,100,000

(A)Which project(s) would the firm undertake if it used the net present value (NPV) investment criterion?

(B)Is this the correct decision? Why?