Financial Math Practice

The following questions have been divided into Fundamental, Intermediate and Short-answer
questions
● For the fundamental level questions, you should be able to attempt them on your own after your
pre–class reading.
● The intermediate level questions are those that you should be able to attempt after your weekly
tutorial session.
● Short-answer questions are slightly more challenging which assess your ability of applying the
learned knowledge to solve questions that are more comprehensive.

Fundamental Level

1. During the period 1990 to 2014, the average yield on 3-month U.S. Treasury bills was 3.04%, the
average inflation rate was 2.64%, the average yield on 30-year Treasury bonds was 5.49%, and
the average return on 30-year Aaa-rated corporate bonds was 6.35%. The real risk-free short-term
interest rate is
A) 0.40%. 3 04 % 2 64
>
only government
= -
.
.

B) 2.13%.
0 40 %
C) 2.97%.
:
.

D) 4.76%.

Treasury
(Bond
Risk-free rate
=

real-rate =
Nominal inflation
rate rate

market
short term
:

1 year/money

long term=1 year (capital market

2. You are considering an investment in a AAA-rated U.S. corporate bond but you are not sure what
rate of interest it should pay. Assume that the risk-free rate of interest is 2.5%; inflation is
expected to be 1.5%; the maturity risk premium is 2.5%; and, the default risk premium for AAA
rated corporate bonds is 3.5%. What rate of interest should the U.S. corporate bond pay?
A) 8.5% (Nominal
B) 6.0% risk premium t befault risk
premium
Risk-free rate + maturity
C) 5.0% Corporate bond pay
=

D)9% 2 5% + 2 5%
= 3 5 % .
.
+ .

= 8 .
5 %

3. You are considering an investment in a U.S. Treasury bond but you are not sure what rate of
interest it should pay. Assume that the real risk-free rate of interest is 1.0%; inflation is expected
to be 1.5%; the maturity risk premium is 2.5%; and, the default risk premium for AAA rated
corporate bonds is 3.5%. What rate of interest should the U.S. Treasury bond pay?
A) 8.5% Bondong term)
B) 6.0% T

C) 5.0% long-term
c
D) 2.5% maturity-risk
inflation premium
+
bond real risk rate + premium
Treasury -

rate

1 5 + 1 5
1 %
.

I + .

: 5 .
0 % 1
4. You discover an antique in your attic that you purchased at an estate sale 10 years ago for $400.
You auction it on eBay and receive $8,000 for your item. What annual rate of return did you earn?
$400 1/10
A. 20.00% 10 years ago 8000
120) 1
B. 30.47%
-

M
=
=
10
400
C. 34.93% PV =
-400
In
D. 200.00% 0000 3
ending value
Fr =

return ?
YYR Initial value
FU rate of
annual
PV :

(1 + 2)
8000
400 =
=
34 .
93 %
(1 +
2)10
5. O wen expects to receive $20,000 at the beginning of next year from a trust fund. If a bank loans
money at an interest rate of 7.5%, how much money can he borrow from the bank based on this
information?
$20 000
Fu = ,

A. $15,000 5%
I/YR = 7 .

B. $21,500 I
N =

C. $11,428
D. $18,605 PV :?

000 $18 605/1

,
20 ,
=
,

= I
pr n
(1 + = 5%.

6. You are scheduled to receive $10,000 in one year. An increase in the interest rate will have what
effect on the present value of this cash flow?

A. It will have no effect on the present value.

B. It will cause the present value to fall.
C. It will cause the present value to rise.
D. The effect cannot be determined with the information provided.

7. Sara wants to have $500,000 in her savings account when she retires. How much must she put in
the account now, if the account pays a fixed interest rate of 8%, to ensure that she has $500,000 in
20 years' time?
$500 000
FV = ,

A. $180,884
8%
I/R
=

B. $107,274
C. $144,616 H = 20 years
D. $231,480

2
8. If you only earned interest on your initial investment, and not on previously earned interest, it
would be called simple interest.

A. True
B. False\

9. Which of the following investments has the highest effective annual return (EAR)? (Assume that
all CDs are of equal risk.)
Ear 7 38
A. a bank CD that pays 7.25 percent compounded semiannually
=
2
.

m =

7 25 %
B. a bank CD that pays 7.00 percent interest compounded daily m 365 EAR = .

C. a bank CD that pays 7.30 percent annually EAR 7 3 % : .

7 34 %
D. a bank CD that pays 7.10 percent compounded monthly m : 1 EAR : .

3
1

1"
M 2

EAR :
i
[1 + ]
-

1) E =
[1 + = 25 % ]2 =

T 2

10. You believe in the power of compounding and decide to save $1 per day by avoiding the purchase
of a soda. You deposit the $1 at the end of each day in a bank account that pays 8% interest
compounded daily. You are going to take a trip in 20 years with the money you have accumulated.
How much money will you have in 20 years, assuming 365 days per year?
ic"-1]
A.
B.
$7,500
$12,438
PMT
=
$1
TV :

PMT (11 +

365x20
↓
C. $22,456 I/YR :
0 % I
1 + 8% ) - 1

D. $18,032 365 days 8%

365
N =
365X20
Fu = 18 ,
032
FV
= ?

11. A lender lends $10,000, which is to be repaid in annual payments of $2000 for 6 years. Which of
the following shows the timeline of the loan from the lender's perspective?
A.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
$0 $2000 $2000 $2000 $2000 $2000

B.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
-$10,000 $2000 $2000 $2000 $2000 $2000

C.
Year 0 Year l Year 2 Year 3 Year 4 Year 5 Year 6
-$10,000 $2000 $4000 $6000 $8000 $10,000 $12,000

3
 D.
Year 0 Year l Year 2 Year 3 Year 4 Year 5 Year 6
-$10,000 $2000 $2000 $2000 $2000 $2000 $2000

12. A tenant wants to lease a building for $48,000 per year. She signs a five-year rental agreement
that states that she will pay $24,000 every six months for the next five years. Which of the
following is the timeline for her rental payments, assuming she makes the first payment
immediately?
A.
1 1 1 1
Year 0 1/2 1 1 2
2 2 2
3 3 2
4 4 2
5
CF -24 -24 -24 -24 -24 -24 -24 -24 -24 -24 0
($000
)
B.
1 1 1 1
0 1/2 1 1 2
2 2 2
3 3 2
4 4 2
5
Year
CF 24 24 24 24 24 24 24 24 24 24 24
($000
)
C.
Year 0 1 2 3 4 5
CF 48 48 48 48 48 48
($000
)
D.
Year 0 1 2 3 4 5
CF -48 -48 -48 -48 -48 -48
($000
)

Topic 4
13. Samantha enters a rent-to-own agreement for living room furniture. She will pay $60 per month
for one year. Which of the following shows the timeline for her payments if the first payment is
one month from now?
A.
Mont 0 1 2 3 4 5 6 7 8 9 10 11 12
h
CFs ($) 0 -60 -60 -60 -60 -60 -60 -60 -60 -60 -60 -60 -60

B.
Month 0 1 2 3 4 5 6 7 8 9 10 11 12
CFs($) -60 -60 -60 -60 -60 -60 -60 -60 -60 -60 -60 -60 -60

4
 C.
Mont 0 1 2 3 4 5 6 7 8 9 10 11 12
h
CFs ($) -60 -120 -180 -240 -300 -360 -480 -54 -60 -66 -720 -780 -84
0 0 0 0

D.
Mont 1 2 3 4 5 6 7 8 9 10 11 12
h
CFs -$60 -$60 -$60 -$60 -$60 -$60 -$60 -$60 -$60 -$60 -$60 -$6
0

Topics 3 & 4
14. The timeline shown below best describes the cash flow of which of the following people?
Date (years) 0 1 2 3 4
Cash Flows -$3500 $1000 $1000 $1000 $1000

A. Karen, who loans a friend $3500, and whose friend pays back the loan in four annual
instalments of $1000
B. Joe, who puts down $3500 to buy a car, and then makes annual payments of $1000
C. Harry, who borrows $3500, and then receives an annual payment of $1000
D. Leo, who borrows $3500, and then pays back the loan in four annual payments of $1000

15. A homeowner in Queensland has the opportunity to install a solar water heater in his home for a
cost of $2400. After installation, the solar water heater will produce a small amount of hot water
every day, forever, and will require no maintenance. How much must the homeowner save on
water heating costs every year if this is to be a sound investment? (The interest rate is 9% per
year.
PV = 2400
A. $216 PMT
Pr X i

PMT
:

B. $248 PV :
09
=
/Ym = 0 .

C. $240 = 2400 X0 .
09
D. $262
=
216

5
16. You are saving money to buy a car. If you save $300 per month starting one month from now at
an interest rate of 4%, how much will you be able to spend on the car after saving for 4 years?

A. $41,778.96 #V = ?
B. $15,287.27 PMT = 300
C. $13,286.65 4%
D. $15,587.88 /R =

12

M
= UX 12

17. You are borrowing money to buy a car. If you can make payments of $300 per month starting one
month from now at an interest rate of 4%, how much will you be able to borrow for the car today
if you finance the amount over four years?

PMT1
A. $15,587.88 PMT = 300
FU + is
B. $6,358.54
:

C. $13,067.62 #/YR 4/12 =

D. $13,286.65 N = 4 X 12

pu =
?
:
300
(11 +
u(4x 1)
4/12

286 65
= 13 ,
.

Topic 4
18. Dan buys a property for $250,000. He is offered a 20-year loan by the bank, at an interest rate of
6% per year. What is the annual loan payment Dan must make?
<PV of Ordinary annually
Mortgage PV
A. $21,796.14 - 250000
B.
C.
$32,684.66
$64,486.34
ou .

PMT <1 -

citis 6 =/YR

D. $24,864.98 20
N
1
PMT
250000
=

(1 =
207 PMT ?
6% (1 + 6 %(

In
PMT = 21 ,
796 .

6
 BEG
>

19. What is the present value of an annuity of $4,000 received at the beginning of each year for the
next eight years? The first payment will be received today, and the discount rate is 9% (round to
the nearest $1).
BEG

A. $24,132 4000 PMT

B. $25,699 N
&
C. $35,712
D. $36,288 9
I/YR

20. Your company has received a $50,000 loan from an industrial finance company. The annual
payments are $6,202.70. If the company is paying 9 per cent interest per year, how many loan
payments must the company make?

A. 12 5000 Pu
B. 19
-

C. 13 97/YR
D. 15 PMT
6202 .
7

M
?

21. You are interested in purchasing a new car that costs $35,000. The dealership offers you a special
financing rate of 6% APR (0.5% per month) for 48 months. Assuming that you do not make a
down payment on the car and you take the dealer's financing deal then your monthly car payments
would be closest to the following:

A. $822 35 000
PMT it
,

PV =

ou :

B. $647 6/12
C. 842
/YR
D. $729 N 48

PMT ?

7
O
22. A rich donor gives a hospital $100,000 one year from today. Each year after that, the hospital will
receive a payment 5% larger than the previous payment with the last payment occurring in ten
years' time. What is the present value (PV) of this donation, given that the interest rate is 9%?

A) $585,987.27 Growing annuity

B) $467,922.22
C) $779,843.27
D) $772,173.49
~ or
: 11
(i -

9)
-
= 100

19 %
, 000

-
5% ) -
- $779 843 27
,
.

23. The required rate of return reflects the costs of funds needed to finance a project.

A. True
B. False

cost of Capital =
WAC) =

required rate-cost funds =

of

of return

24. The cash flows for four projects are shown below, along with the cost of capital for these projects.
If these projects are mutually exclusive, which one should be taken?
"Co
A. - 20 , 000 [F]
Year 0 1 2 3 4 5 , 000
6
CFJ

CF -20,000 $6000 $6000 $6000 $6000 $6000

5 CFj(iy)
WACC 8% -

8 /PR
3 956 26
< ,
.

B. -
PRC

Year 0 1 2 3 4 5
CF -15,000 $4000 $4000 $4000 $4000 $4000
WACC 7%
> 1 , 400 .
79
C.
U2
Year 0 1 2 3 4 5 = 2229 .

CF -18,000 $5000 $5000 $5000 $5000 $5000

WACC 7.5%
D.
5317 9
Year 0 1 2 3 4 5 = .

CF -12,000 $4000 $4000 $4000 $4000 $4000

WACC 5%
8
⑧ 25. An investor has the opportunity to invest in four new retail stores. The amount that can be
invested in each store, along with the expected cash flow at the end of the first year, the growth
rate of the concern, and the cost of capital, are shown for each case. It is assumed that that each
investment will operate in perpetuity after the initial investment. Which investment should the
investor choose?

A) Initial investment: $100,000; Cash flow in year 1: $12,000; Growth Rate:

1.25%; Cost of Capital: 9.0%
B) Initial investment: $90,000; Cash flow in year 1: $10,000; Growth Rate:
1.50%; Cost of Capital: 9.0%
C) Initial investment: $80,000; Cash flow in year 1:$8000; Growth Rate: 1.75%;
Cost of Capital:8.0%
D) Initial investment: $60,000; Cash flow in year 1: $6000; Growth Rate: 2.50%;
Cost of Capital: 7.5%

=
PV costs
NPU = PV benefits

=
PMT COSTS

(i -
9)

1200
a) NPU =
15
> -
100, 000 = 53846 .

9% -
5%

b) NPV : 10000 - 90000 =

13333 .
33

9%
-
5%

0000
NPV 40, 000
=
c) -
80000 :

1 25 %
8%
- .

6000 = 60 , 000
D) MPV =
- 6000

7 5%.
-
2 5 .

9
 Intermediate Level

26. Which one of the following statements is FALSE?

A. A dollar today and a dollar in one year are not equivalent.

B. The equivalent value of two cash flows at two different points in time is sometimes referred to
as the time value of money.
C. Finding the present value (PV) and compounding are the same.
D. If you want to compare or combine cash flows that occur at different points in time, you first
need to convert the cash flows into the same units or move them to the same point in time.

O
27. You have been depositing money at the end of each year into an account drawing 8% interest.
What is the balance in the account at the end of year four if you deposited the following amounts?

Year End of Year Deposit

1 $350
2 $500
3 $725
4 $400

O 1234
A. $2,207 CFy O

I
B. $1,622 350
I I I

no
HPV ? 500 zas
C. $2,687 500 o 350
D. $2,384 1 725
400

I/P J
1622 28380
HPV ?
= .

PV (1 + z)d
Fu =

2
(1 + 0% /"
= 1622 .
28380

207 099
=
2 , .

10
28. Which of the following investments has a higher present value, assuming the same (strictly
positive) interest rate applies to both investments?

Year Investment X Investment Y

1 $5,000 $11,000
2 $7,000 $9,000
3 $9,000 $7,000
4 $11,000 $5,000

A. Investment Y has a higher present value.

B. Investment X and Investment Y have the same present value, since the total of the cash flows
is the same for both.
C. Investment X has a higher present value.
D. No comparison can be made. We need to know the interest rate to calculate the present value.

NPV
NPUy c

29. An investment pays you $20,000 at the end of this year, and $10,000 at the end of each of the four
following years. What is the present value (PV) of this investment given that the interest rate is
4% per year? O I
23 Y 5
O
CFy I I I I I I

10000 10000 10000 10000

A. $58,614 20 000 O 20000

10 , 000 60792
B. $45,913 mou =
Enmcf =
54133 .

C. $54,134 4 N] 0(1 + k)t

+ =
54134//
4/YR
=

D. $42,150
NPV ?

11
30. Which of the following conclusions would be true if you earn a higher rate of return on your
investments?

A. The greater the present value would be for any annuity you would receive in the future.
B. Your rate of return would not have any effect on the present value of any
sum to be received in the future.
C. The greater the present value would be for any lump sum you would receive in the future.
D. The lower the present value would be for any lump sum you would receive in the future.

t
pr
I ,&

O
31. A bank is negotiating a loan. The loan can either be paid off as a lump sum of $100,000 at the end
of five years, or as equal annual payments at the end of each of the next five years. If the interest
rate on the loan is 10%, what annual payments should be made so that both forms of payment are
equivalent? Fu
13231 PV
100 000 6209
1 PU =
FU -
.

A. $16,380 (1 + 2) FYR 10 10 I/R

B. $12,000
N
C. $19,588 =
100 , 000
N5 5
D. $20,000 PMT
(1 + 10 % )5 pr ? ?

1 2
13231
=
62092 .

32. Salvatore has the opportunity to invest in a scheme which will pay $5000 at the end of each of the
next 5 years. He must invest $10,000 at the start of the first year and an additional $10,000 at the
end of the first year. What is the present value of this investment if the interest rate is 4%?

10000 CF]
A. -$1410.67 -

B. -$112.23 - 5000
CF]
C. $2643.73
CF]
D. $1248.56 5000

4 HJ
-

4
I/YR

? NPU 12
33. A perpetuity will pay $1000 per year, starting five years after the perpetuity is purchased. What is
the present value (PV) of this perpetuity on the date that it is purchased, given that the interest rate
is 4%?
Fr
25000
A. $34,604 Y
M

B. $1,410 I/YR
y
C. $21,370
D. $20582 Pu

34. A perpetuity will pay $1000 per year, starting five years after the perpetuity is purchased. What is
the future value (FV) of this perpetuity, given that the interest rate is 4%?

A. $21,370
B. $20,582
C. $1410
D. There is no solution to this problem.

35. A month after you were born, your grandparents have been depositing $100 into a savings
account every month. The account pays 4% interest annually. Immediately after your
grandparents make the deposit on your 18th birthday, the amount of money in your savings
account will be closest to:

A. $11,941,266 PMT = -100

B. $21,600 Y
I/yR =

C. $30,774 12

D. $31,559
=
4x12
M

Fu = ?

13
36. You are thinking about investing in a mine that will produce $10,000 worth of ore in the first year.
As the ore closest to the surface is removed, it will become more difficult to extract the ore.
Therefore, the value of the ore that you mine will decline at a rate of 8% per year forever. If the
required rate of return for this project is 6%, then the value of this mining operation is closest to:

A. $71,429 Growth rate = -8 % (negative (

B. $166,667 CF1 10 000
10 000
Pu =

C. $500,000 =
=

6% ( 8t ) 14 %
i
-

g
- .

D. This problem cannot be solved.

=

=
D71 ,
429

O
37. Two mutually exclusive investment opportunities require an initial investment of $5 million.
Investment A then generates $1.5 million per year in perpetuity, while investment B pays
$1million in the first year, with cash flows increasing by 3% per year after that. At what cost of
capital would an investor regard both opportunities as being equivalent?

A. 10% PU
PU benefit
-
costs
B. 3% NPU =

C. 9%
D. 6%
PMT
PMT MPVB
MPV
=
=
=
+ =
g
I I

-
5 +
! = -
5 +

2 - 0 . 03
I

15 =
3 =
0 .
03

38. If the interest rate is positive, then the present value of an annuity due will be less than the present
value of an ordinary annuity.
A. True
B. False

39. The future value of an annuity will increase if the interest rate goes up, but the present value of
the same annuity will decrease as the interest rate goes up.~

A. True
B. False

14
O
40. A deferred annuity will pay you $500 at the end of each year for 10 years, however, the first
payment will not be made until three years from today (payments will be made at the end of years
3 through 12). What amount will you have to deposit today to fund this deferred annuity? Use an
8% discount rate and round your answer to the nearest $100.

A. $2,900 500 PMT FV 04070

3355
:

1 2 .

B. $2,400 O +
YR N = 2
C. $2,200
D. $3,400 10 M I/R = 8%

pu ?
? pV :

355 04070 = 2876 .

4066
pr =
3 ,
.

= 2900/

41. An investor is considering the two investments shown below. Which of the following statements
about these investments is true?

Year 0 1 2 3 4 5 Discount
rate
Investment -$1.5 $300,000 $300,000 $300,000 $500,000 $500,000 8%
A m
Investment -$1.3 $500,000 $400,000 $300,000 $200,000 $100,000 7%
B m

A. The investor should take investment A since it has a greater internal rate of return (IRR).
B. The investor should take investment A since it has a greater net present value (NPV).
C. The investor should take investment B since it has a greater net present value (NPV).
D. Neither investment should be taken since they both have a negative net present value (NPV).

IRV A inv B

3789 567 7655Y

MPV 19 064 NPU 14 .
= -

= ,
, .

IRR :
6 46173
56415
.

IRR :
7 .

15
 SHORT ANSWER QUESTIONS

● Some questions below are provided with full workings to demonstrate the requirement of
solving financial math questions.
● Most of the following questions only provide with hints and final answers. The missing
working steps will be discussed in class.
● Please note that working steps must be provided to earn full marks

42. You signed a rental lease for an office space in Clayton for four years with an annual rent of $1
million, paid at the beginning of each year of the lease. Just before you pay your first rent, the
property owner wants to use the space for another purpose and proposes to buy back the lease
from you. The rent for similar space is now $1.25 million per year. Draw a timeline and calculate
the minimum compensation that you would ask from the property owner. Assume the interest rate
to be 6%.
mode on (
annuity due (begining

3
O I 2 34
I I 1 I

Imm Imn Imn

Imn Imm

PMT 12-cin]
(1 + 2
pu :

14]
I
%
-

11 + 6%
6

43. Assume that you take a 10-year mortgage for 100,000 at 8.5% p.a. It is to be repaid monthly.
a) What is the monthly repayment amount? Assume the interest is compounded monthly
b) How long does it take to pay off 40% of the loan (i.e. to have $60 000 outstanding)?
c) What is the balance outstanding after two years?
d) After two years the interest rate falls to 8% p.a. what prepayment penalty would make it
unattractive to prepay the loan. (prepayment penalty is the fine imposed by the banks on the
borrowers for prepaying their mortgage for the purpose of refinancing it at the lower interest
rates)

16
44. You are planning to invest $5000 and the financial manager from the Westpac bank gives you the
following investments to consider

● Investment 1: $1500 paid every year for 5 years, with the first payment to be received at the
end of year 2
● Investment 2: $600 paid semiannually for 5 years
● Investment 3: $100 paid at the end of first quarter and it will grow 1% quarterly forever

a) What is the annual percentage rate of return of each investment?

b) Calculate the effective annual rate of return of each investment.
c) Which investment should you choose?

17
45. Your rich aunt offers you the choice of 2 pay-outs today

Choice 1: $1000 paid every year for 5 years, with the first payment to be received at the end of year 4
Choice 2: $3000 paid today

If the discount rate and compounding rate are both 10%, identify the better offer.

choice I

$ 1000 PMT

M
5

10 %
F/YR

18
46. Faisal has $15,000 in his savings account and can save an additional $5000 per year. If interest
rates are 12%, how long will it take his savings to grow to $50,000?

47. It is your 6th birthday today. You have a trust fund with $50,000 that is earning 8% per year. You
expect to withdraw $30,000 per year for 7 years starting on your 22nd birthday for graduate
school. How much money will be left in the trust fund after your last withdrawal?

19
48. You are going to pay $800 into an account at the beginning of each of 20 years. The account will
then be left to compound for an additional 20 years until the end of year 40, when it will turn into
a perpetuity. You will receive the first payment from the perpetuity at the end of the 41st year. If
the account pays 14%, how much will you receive from the perpetuity each year ?

PMT = 800

M = GOX 12

F/yR = 14 %

:
FV

49. You estimate you'll need $200,000 per year for 25 years starting on your 65th birthday to live on
during your retirement. Today is your 50th birthday and you want to make equal deposits into an
account paying 9% interest per year, the first deposit today and the last deposit on your 64th
birthday. How much must each deposit be?

20
50. As a new migrant, Lisa is currently considering to buy a bottle shop that will be in operation for
10 years. If purchased, the bottle shop is expected to generate a first cash flow of $90,000 this
year which is expected to grow at 6.5% p.a. The offer to purchase the business is $500,000. She
plans to borrow this money from one of her friends and he requires 14.5% rate of return p.a.
Evaluate this project and identify if it is worth buying.

51. You are planning to buy a petrol station, which costs $500,000. The station will be in operation
for 10 years. If purchased, the business is expected to generate a first cash flow of $90,000 this
year which is expected to grow at 6.5% p.a. If the similar business offers 14.5% p.a. rate of return,
use IRR and NPV approach to identify if it is worth buying.

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52. You are considering investing in a new gold mine in South Africa. Gold in South Africa is buried
very deep, so the mine will require an initial investment of $200 million. Once this investment is
made, the mine is expected to produce revenue of $30 million per year for the next 20 years. It
will cost $10 million per year to operate the mine. After 20 years, the gold will be depleted. The
mine must then be stabilised on an ongoing basis, which will cost $4 million per year in
perpetuity. If 40% of the capital is financed through debt which has a cost of 2% and the
shareholders expect a 5% premium on what creditors earn.
a) Calculate the required rate of return of this project.
b) Use NPV approach to identify if you should invest in this project.

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53. Starfish Ltd. specialises in making canned Tuna and currently buys cans from an outside supplier
at $0.25 per can. It requires 2,000,000 cans per year. Starfish is considering producing the cans
itself instead of buying them. Direct in-house production cost is estimated to be 0.15 per can. To
produce the cans, it would cost $600,000 to purchase and install the equipment today. The life of
the equipment will be 5 years after which it is expected to be sold for 20% of the original cost.
The equipment will also need to be maintained in the second year of production for a cost of
$30,000.

Starfish has 60% of its capital financed through equity costing 15% p.a. The debt holders are
willing to charge 2% less on what the shareholders earn.

a) Draw the timeline and set out annual cash inflows, outflows and net cash flow by year.

b) Calculate the Net Present Value (NPV) of this project. Explain if the project should be
accepted according to NPV decision rule.

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