FIN 422 Practice Midterm 2019
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FIN 422 Practice Midterm
Department of Finance and Statistical Analysis
2019
1. You are evaluating whether to build a petrochemical complex or a refinery plant in Strathcona county on behalf of investors. Due to capacity constraints, you can only proceed with one of the two projects (i.e. the projects are mutually exclusive). The petrochemical complex requires $10 million i n upfront costs and i s expected to generate $3 million per year (starting i n one year) i n perpetuity, and the refinery plant requires $5 million upfront and is expected to generate $2 million per year (starting in one year) in perpetuity. The cost of capital for both projects is k = 10%.
(a) (2 points) What is the NPV for the petrochemical complex and for the refinery
plant? Which project (if any) should you choose based on the NPV rule?
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Solution: The NPV for the petrochemical complex is NPVpetrol = -10+ |
(b) (3 points) What is the IRR for the petrochemical complex and for the refinery plant? Which project (if any) should you choose based on the IRR rule?
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Solution: The IRR is the discount rate that sets the NPV of the project to zero:
÷ 0 = -10 +
÷ 0 = -5 + Since both IRRs are higher than the 10% cost of capital and Rrefinery is the higher of the two, the IRR rule indicates that you should select the refinery project. |
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Solution: The incremental cash flows of switching from the refinery plant to the petrochemical complex is -10 - (-5) = -$5m incremental outlay and 3 - 2 = $1m incremental inflows in perpetuity. The IRR of this cash flow stream is R defined by 0 = -5 + The incremental cash flow is non-loan type (since it involves an initial cash outflow followed by cash inflows) and the IRR is higher than the 10% cost of capital, so the IRR indicates we should switch from the refinery to the petro- che |
2022-02-15