Question 1

(a) Find the Net Present Value of a project with an initial cost of 500, followed
by revenues of 100 one year later and 500 two years later. Use a
discount rate of 20%.
(b) Use trial and error to guess the approximate internal rate of return.
Question 2
All cost figures have been expressed below in real values (adjusted for inflation).
A lighting system in a hospital clinic cost 50,000 to install. The cost of fitting
energy-saving timer switches is 1000. Annual running costs for lighting will be
reduced by 150 each year for 20 years if the timer switches are used. In
addition replacement cost savings for bulbs come to 50 per year. Calculate
whether the investment is worthwhile at a nominal discount rate of 12% and an
expected inflation rate of 2%. Calculate also the real internal rate of return using
tables.
Question 3
A Bank installed a new web based trading equipment at a cost of 120,000 and it
is now worth 40,000 second hand. Net cash flows are expected to be 25,000
for the next two years. A replacement unit could be installed for 60,000; that
would give net cash flows of 25,000 in the first year and 40,000 in the second.
Regulations mean that both have to be shut down two years from now with no
second-hand value for either system. Sketch out the cash outflow and inflows for
years 0,1,2 for each of the options keep the old system OR buy the new
system.

ANSWERS
1(a). C0 =-500, C1=100, C2 =500
R=20%
NPV=-500+100/1.2+500/(1.2)2

= -69.44

Note: for a longer series of years you might like to use, instead of a calculator,
tables such as Appendix C Pike, PVIF present value interest factor.
1(b). IRR< 20%
Try another discount rate: 10%
NPV > 0
IRR has to be somewhere between 10% and 20%
You can proceed in this way to get a more precise range.
2.
C0=1000, C=200 T (year) = 20
= 12% - 2%=10%

R= 12%

Inflation = 2%

real discount rate

Discounted revenues sum to:

Standard Tables such as Pike Appendix D gives the PVIFA (present value interest
factor for an annuity). This shows the summed value of 1 pound invested at a
certain discount rate each year from year 1 for a certain number of years. PVIFA
=8.5136
Net Present Value: NPV= -1000+200(8.5136) > 0. So, buy the times switches.
Note there is irrelevant information given to you about the cost of the total
system.

3. The patterns are shown below for years 0,1,2. Note that maintaining the old
system needs to be seen as an investment of its opportunity cost i.e. its second
hand value of 40,000

40

60