Business Finance: Analysis of Investment Decisions, Stock Valuation, Portfolio Theory, and Cost of Capital

Business Finance 1
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Question 1

Business Finance 2
(a) The payback period defines the time required for a project to generate cash flow that covers
the initial capital outlay (Sharpe & Litterman, 2014). The payback period for project A is 3.31
years while that of project B is 1.76 years. Under this criterion, the project B is preferred since it
has a lower payback period.
Figure 1
(b) Net Present value is the current value of all future cash flows. The NPV of project A is
$78,055.06 while that of project B is $8094.85. Both investments are desirable because they have
positive NPV. However, Investment A is preferred because its NPV is higher.
Figure 2
(c) The internal rate of return is the discount rate at which the net present value is equal to zero
(Rank, Unger & Gemünden, 2015). Project A has an IRR of 27% while project B has NPV of

Business Finance 3
38%. Since the firms cost of capital is 15%, both investments are worthwhile. However, B is
more preferable than A.
Figure 3
(d) Profitability index measures value generated per unit of investment. Project A has a
profitability index of 1.37 while project B has Profitability index of 1.40. Investment B is
preferred under this criteria because it generates greater value per unit of inflow.
(e) The four methods yield different conclusions. Payback period, internal rate of return and
profitability index support the selection of project B while internal rate of return result prefers
selection of project A. However, the net present value is most preferred by investors because it
considers time value of money and takes in to account all cash flows generated by the
investment.
Question 2
(a) I will be willing to pay $40 for each Wombat share if the required return is 15%.
(b) I will be willing to pay $80 for each Wombat share if the required return is 10%.