FIN701, Spring 2020 AP1 Practical Application for M4

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DHC Development Co. has several new projects that look attractive, but some are riskier than the firm’s
past projects. DHC has received a $15 million inflow of cash from a venture capital firm, in exchange for
20% of the firm’s closely held stock. The VC firm has asked DHC managers to “run the numbers” to
examine both the market outlook and the expected returns on each of the projects they are considering.
For each of the following questions, you will need to show your work. That means to show the
equations used for items such as required return, average expected return, profitability index, etc.
When you are using the financial calculator (or Excel), identify each of your inputs. Anyone
looking at your work should be able to replicate your answer based on the backup info you
provide.

1. Based on DHC’s earnings history over the past 15 years, which have covered various states of the
   economy, the venture capital execs want DHC to estimate their overall returns. Given the following
   estimates of economy over the next several years, determine DHC’s expected rate of return. (3 pts)
   Note, this type of development firm has much higher than normal returns under normal and boom
   conditions.
   State of the
   Economy

Probability
of State of the
Economy

Rate of
Return if
State Occurs
Boom 20% 35%
Normal 55% 12%
Recession 25% -15%
Expected return for “average” company project =

2. Historically, DHC projects have had an average beta of 1.15 Assuming the return on the overall
   market is 9.25% and the risk free rate is 1.5%, what is the required return for an “average” DHC
   project using based on its average project beta? Round the average required return to 2 decimal places
   (x.xx%). Hint: Remember that the market risk premium = return on the market – risk free rate,
   R = Rf + (β*(Rm – Rf)) (3 pts)
   Expected return for “average” company project =
3. The potential projects that DHC is considering have the following expected cash flows. Each project
   has its own unique risk and as such, the beta on each project is given. Using the data from part 2 for
   the risk free rate and market returns, what is the required percentage return for each of the projects?
   Show the required returns to 2 decimals, that is xx.xx% (4 pts)
     Project A Project B Project C Project D
   Beta 1.3 0.9 1.1 1.6

FIN701, Spring 2020 AP1 Practical Application for M4

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4-7. For each project, calculate the NPV, IRR, profitability index (PI) and the payback period. For each
capital budgeting decision tool, indicate if the project should be accepted or rejected, assuming that each
project is independent of the others. Important Note: The venture capital folks have a hard and fast rule on
payback period, all projects must be completed within 6 years or less.
Expected cash flows for the four potential projects that DHC is considering as shown below:
Year Project A Project B Project C Project D
0 -$4,000,000 -$8,000,000 -$6,000,000 -$3,000,000
1 $1,000,000 $1,250,000 $1,500,000 $300,000
2 $1,000,000 $1,250,000 $1,500,000 $500,000
3 $1,000,000 $1,250,000 $2,500,000 $500,000
4 $1,000,000 $1,250,000 $2,500,000 $750,000
5 $800,000 $1,250,000   $750,000
6 $0 $1,250,000   $750,000
7 $800,000 $1,250,000   $750,000
8 $300,000 $1,250,000   $750,000
9   $1,250,000   $750,000
10   $1,250,000   $750,000
I have provided a suggested template for your final answers. Below the grid (and/or next page) is where
you should put all your required backup calculations. If you are working this in Excel, feel free to submit
your Excel sheet, where the equations in the cells will provide the required backup. Be sure to clearly
indicate the required rate of return (from part 3) you are using for each project.

Year Project A Project B Project C Project D

Point
s
Req. Return (use 2
decimals xx.xx%)        

2
4
a NPV (to nearest $1)        
1
4
b NPV accept/reject        
2
5
a IRR (xx.xx%)        
1
5
b IRR accept/reject        
2
6
a
PI (show 2
decimals)        

1
6
b PI accept/reject        
2
7
a
Payback Period
(x.x years)        

1
7
b
Payback
accept/reject        
Please show your supporting equations and/or the calculator inputs below.

FIN701, Spring 2020 AP1 Practical Application for M4

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8. Discuss your results. What I’m looking for is a short discussion of how some capital budgeting
   techniques provide the same accept/reject decision, while others do not. Can this be a problem for the
   firm? Which of the decisions methods seems the most helpful (and why) and which least helpful (and
   why)? (6 points max, no outside sources necessary)
9. Finally, recall that the venture capital firm only provided $15 million in funding. That $15 million is
   the funding that will cover the initial investments required on projects. Assuming all projects that are
   acceptable using the “gold standard”, NPV, which of those projects should be accepted, while staying
   within the $15 mm budget. Identify the projects that should be accepted, the total outflow at time 0
   (must be within your budget) and the total NPV. (2 pts) Hint: look at Practice Problem 14.