Project Appraisal

Final Test
June 6, 2022

School Year 2021-22 Exam’s Solution Topics

GOOD WORK AND GOOD LUCK!

PART I
1. The CFO of Gant Technologies has asked you to point out which of IRR and NPV
is the best criterion to appraise an IT project called ‘Pegasus’. Project ‘Pegasus’
requires frequent upgrades along its economic life, making net cash flows to be
negative in several years. What is your recommendation? Please justify. [1.5 pts]
The recommended criterion is NPV because with net cash flows crossing
zero more than once we may have more than one IRR solution.

2. Gant Technologies has been asked by the government of Mali to develop and
operate a procurement platform under a 4-year contract. Engineers have come
up with three possible solutions named projects ‘Mark1’,’Mark2’ and ‘Mark3’
whose financials are in the table below. Concerned about socio-political stability
Gant requires that the dynamic payback period be no longer than 3 years. Which
project do you recommend Gant to undertake? Please justify. [1.5 pts]

Million Euros
IO PV CF1 PV CF2 PV CF3 PV CF4 NPV
Mark1 -100 33.4 33.3 33.3 33.3 33.3
Mark2 -150 30 40 60 70 50
Mark3 -125 41.6 41.7 41.7 41.7 41.7
IO = Initial Outlay
PV CFj = Present Value of Cash Flow year j
NPV = Net Present Value
Both project Mark1 and Mark3 have a dynamic payback of 3 years (see
table below). Since Mark3 has a higher NPV this should be the
recommended project.

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 Cumulative PV Cash Flow

1 2 3 4
Mark1 -66.6 -33.3 0
Mark2 -120 -80 -20 50
Mark3 -83.4 -41.7 0

3. Gant Technologies’ portfolio of 6 IT projects in Poland amounts to 11 million

euros, but the CFO has budgeted for that country only 6 million. The company
target debt-to-equity is 1, the tax rate is 20%, the cost of equity is 8%, the before-
tax cost of debt is 4%, and since Polish projects carry an above standard
company business risk an additional 0.5% is added to the WACC.
a. Compute the appropriate discount rate [1.5 pts]

WACC = CoD (1-Tax Rate) (D/C) + CoE (1- D/C) + 0.5%

D/C = (D/E) / (1 + D/E) = 1/(1+1) = ½ = 0.5

WACC = 4% (1-20%) (0.5) + 8% (1-0.5) + 0.5% = 6.1%

b. Given the information below regarding the 3-year Polish projects, the
capital budget, and the discount rate apply the MIRR criterion to advise
on which projects should be implemented. Please justify. [1.5 pts]

According with the MIRR criterion eligible projects must be ranked in terms
of their MIRR. Eligible projects are those with a MIRR higher than the
discount rate. Eligible projects with the highest MIRR are selected until the
capital budget is exhausted. Projects Zakopane and Gdańsk have the
higher MIRR but do not exhaust the capital budget, leaving 1 million
unspent. Project Poznań can not be implemented since its investment is
above the remaining available budget; the other 3 projects’ MIRR is below
the discount rate, hence they do not add value to the firm, and they should
not be implemented either.

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 Amount Available
Projects MIRR 6
in 10 Budget
Zakopane 8% 3 3
Gdańsk 7% 2 1
Poznań 6.25% 2
Krakow 6% 1 Below
Wrocław 5.50% 2 Discount
Warsaw 5% 1 Rate

PART II
4. ISEG will become a foundation and has asked you to study the financials of
moving to a new campus in Cascais, near the beach. The investment amounts
to 200 million euros and is to be held for 100 years. The current premisses will
be sold for 125 million euros to help funding the acquisition of the new campus.
The written down book value of the current premises is 25 million euros. The
move is expected to attract more international students and improve revenues by
2.5 million euros per year in the first 5 years and by 5 million euros thereafter.
Operating margin is estimated at 50%. ISEG will be exempt from income tax but
is liable to the real estate transaction tax of 5%, paid by the buyer, and a tax of
30% over the difference between the sales value and the written down book value
of the property. The expected written down book value of both premisses in 100
years’ time is zero. A special grant from the EU is expected in each of the first 5
years and should amount to 1 million euros per year. All figures are in real values.
The expected real increase in property values in Cascais is 0.5% per year and
1% per year in Lisbon. The real discount rate is 1.8%.
a. What would be your advice regarding the relocation project based on the
projects’ NPV? [2.5 pts]
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Capital Flows in € 10
Initial Flows EOY0
Initial Investment -200
RE Transaction Tax ( = 5% x 200) -10
Sale current premisses 125
Tax on Sale ( = 30% x (125 - 25) ) -30

Terminal Flows EOY100

100
Sale value of new campus net of tax (= 200x(1+0.5%) x(1-30%) 230.5
100
Sale value of old campus net of tax (= 125x(1+1%) x(1-30%) -236.7

Operating Cash Flows EOY

1-5 6-100
Incremental Operating Income (=50% x Incremental Revenues) 1.25 2.50
EU Grant 1.00 0.00
Net cash flow 2.25 2.50

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 Net Present Value Factors PV
Initial Capital Flows -115
Terminal Capital Flows -1.0
Annuity 5 years 4.74
NCF Years 1-5 10.7
Deferred Annuity 95 years 41.48
NCF Years 6-100 103.7
NPV -1.7
The NPV is negative, hence the recommendation to ISEG based on the
provided financials is not to move to a new campus.
b. If ISEG can negotiate a special exemption of the real estate transaction
tax would your advice be different? [1.5 pts]
Net Present Value Factors PV
NPV with zero RE transaction tax 8.3
The NPV becomes positive without the real estate transaction tax on the
new campus acquisition value paving the way to a positive
recommendation regarding the relocation project.
5. Brown Bear is a UK-based company that currently has a debt-to-equity of 25%
but intends to raise new debt and bring the aforementioned ratio to 50%. A
regression of its stock returns on the returns of the market index has produced
the following results: RBB = 1.3% + 1.20 RMarket. The company’s tax rate is 30%.
What will be the beta of Brown Bear after the increase in leverage? [1.5 pts]
First, we need to determine BB unlevered beta by using the relationship:
Unlevered Beta = Levered Beta / (1 + (1 - Tax rate) x (Current Debt/Equity)).
Afterwards, we re-lever the beta using the target debt-to-equity of 50% on:
Levered Beta = Unlevered Beta * (1 + (1 - Tax rate) x (Target Debt/Equity)).
Before After
Levered Beta 1.20 1.38
D/E 25% 50%
Tax Rate 30% 30%
Unlevered beta 1.02

PART III
6. Metsä Group is a Finnish forestry company that owns a stand of spruce that it
intends to harvest and has no plan for a second crop as it intends to use the land
to build a mall. The projected harvest income (in thousands of euros) for the
relevant harvest years is presented in the table below.
EOY
5 6 7 8
Harvest Income 151 159 165 170

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a. Assuming a 5% discount rate, what is the best time to harvest? [1.5 pts]

The highest NPV determines the optimal harvest year that in this case
is the 6th year.
EOY
5 6 7 8
Harvest Income 151 159 165 170
NPV 118.3 118.6 117.3 115.1
Discount Rate 5%
Max. 0 1 0 0
Decision 6

b. Metsä Group funding is composed of 1,000 in equity, 200 in bonds and

300 in convertible bonds (all figures in million euros). The CFO asks you
to recompute the WACC considering the cost of equity is 7%, pre-tax cost
of debt is 2.5% (average maturity is 10 years), the convertible time to
maturity is 10 years, its coupon is 1.986%, its nominal value 100 euros,
its current value is 150 euros, and the tax rate is 20%. [2.5 pts]

To compute the WACC we need first to decompose the value of the

convertible bond in a bond component and an equity component.
We calculate the value of the bond component by discounting the
convertible coupon stream and principal repayment using the pre-
tax cost of debt of 2.5%. The difference of the convertible value and
the value of the convertible’s bond component is the value of the
equity component. Adding these two values to the bond and equity
funding figures allow us to calculate their respective weights. These
weights are then used to compute the WACC.

Pre-tax CoD 2.50%

Convertible Time to Maturity 10
Convertible Coupon 1.986%
Convertible Current Value 150
Number Convertibles 2 000 000
Convertible: 1 2 000 000
Coupon Annuity 17.4
Principal 78.1
Total value @ 2.5% 95.5
Straight Bond Component 95.50 € 191 000 000
Equity Component 54.50 € 109 000 000
Total Value 150.00 € 300 000 000

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 6
Funding in € 10
Equity 1000
Bond 200
Convertible 300
Total 1500

Adjusted Figures weight

Equity 1109 73.9%
Bond 391 26.1%
Total 1500

Tax Rate 20%

CoE 7.0%
CoD After Tax 2.0%
WACC 5.70%

c. What is the best time to harvest using your estimated WACC? [1.5 pts]

EOY
5 6 7 8
Harvest Income 151 159 165 170
NPV 114.5 114.0 112.0 109.1
Discount Rate 5.7%
Max. 1 0 0 0
Decision 5

PART IV
7. A contractor has presented to the relevant French interdepartmental roads
directorate three options to pave a non-concession motorway, with different
investment costs, yearly maintenance costs and economic life, which are
summarized in the table below. Considering a 5% discount rate, what would be
your recommended option? [2 pts]
10^3 € per Km
Pavement Investment Yearly Maintenance
Life (years)
Type Cost Cost
Standard 5000 1000 10
Premium 10000 750 15
Ultra 15000 250 20
The projects have different lives, so we need to consider an infinite
replacement chain and calculate the NPVs in perpetuity. The lowest NPV
of all costs should be the solution to recommend: the Ultra pavement type.

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 Pavement Investment Maintenance
NPV NPVp
Type Cost Annuity
Standard 5000 7721.735 12 721.735 32 950.457
Premium 10000 7784.744 17 784.744 34 268.458
Ultra 15000 3115.553 18 115.553 29 072.776

8. Cerebos, a high-tech company, is faced with the need to select among a group
of 10 investment projects numbered 1 to 10, all with positive NPV, due to capital
constraints. The sum of capital requirements is € 10 million and the capital budget
available is € 2 million. Projects 1 to 8 can be either fully implemented or not at
all. Projects 9 and 10 can be partially implemented. Projects 2 and 3 are
replacement projects and only one can be implemented. Project 7 is contingent
on the approval of project 5. Investment in project 10 must be at least three times
the investment in project 9. To select the projects to implement the firm intends
to use linear programming. Formulate the corresponding problem stating the
objective functions and the required constraints. [1 pts]
Max Σ Xi x NPVi , i=1,…,10
s.t.
Xi = {0,1} , i = 1, …,8
0 =< Xi =< 1 , i= 9,10
Σ Xi x Ii =< 2
X2 + X3 = 1
X7 =< X5
3 x X2 x I2 – X10 x I10 =< 0

Ii = Investment in project i
NPVi = NPV of project i

YOU HAVE CONCLUDED. EXCELLENT!