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# Financial management problems

A firm is considering two mutually exclusive investments, each with an ititial outlay of 100,000 dollars and an expected life of 3 years. Assume that the firm has a cost of capital of 10 % for each project The 2 investments are of equal risk and have the following cash flows

investment A investment B

year 0 100,000 100,000
year 1 40,000 55,000
year 2 50,000 55,000
year 3 110,000 55,000

Calculate the payback period and the net present value for each investment. Show all of your calculations

Based on the NPV and payback period calculations, which investment should the firm choose?

2. What is the basic relationship between interest rates and bond prices and why does this relationship exsist

3. Why is prefered stock condidered to be a hybrid security?

#### Solution Preview

1. The payback period is the time taken to recover the initial investment. Project A has an initial investment of \$100,000. In 2 years the recovery is 40,000+50,000=90,000. There is still a balance of \$10,000 from the initial investment. In year 3 the project earns \$110,000. we need to find the time taken to earn \$10,000. In 12 months the project earns \$110,000, so time taken for \$10,000 is (12/110,000) X 10,000=1.1 months
The payback period for Project A is 2 years and 1.1 months
Project B earns 55,000 in year 1, so the balance is 45,000 ( initial investment 100,000 less the earnings of 55,000 in year 1). This is to be recovered in year 2. In year 2 the project earns \$55,000, to earn 45,000 it will take (12/55,000) X 45,000=9.8 months. The payback period for project B is 1 year and 9.8 months

The Net Present Value(NPV) - In NPV calculations we sum the present value of the inflows and subtract the initial investment.
Project A, the cash flows are 40,000, 50,000 and 110,000 over the 3 years and ...

#### Solution Summary

The solution has problems in financial management relating to NPV, payback, interest rates and bond prices and preferred stock.

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