- CFA Exams
- CFA Level I Exam
- Topic 3. Corporate Issuers
- Learning Module 5. Capital Investments and Capital Allocation
- Subject 2. Capital Allocation

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**CFA Practice Question**

Tom and Erdal are planning on forming the Top-Torque Company. The company is to specialize in diesel engine rebuilding for extractive industries. The investment cost is expected to be $1.5 million and have after-tax cash flows of $100,000 in year 1, $250,000 in year 2, and $300,000 thereafter indefinitely. The two owners estimate that this is a risky venture and requires a 17% rate of return. What is the value of Top-Torque, and should the investment be made?

B. $1,557,240; yes

C. -$57,240; no

A. $57,240; yes

B. $1,557,240; yes

C. -$57,240; no

Correct Answer: A

NPV = -1,500,000 + 100,000/1.17 + 250,000/1.17

^{2}+ (300,000/.17)/1.17^{2}= -1,500,000 + 1,557,240.04 = $57,240.04###
**User Contributed Comments**
27

User |
Comment |
---|---|

zhaojiang |
NPV = -1,500,000 + 100,000/1.17 + 250,000/(1.17)(1.17) + (300,000/0.17)/(1.17)(1.17) |

kunam |
if 300,000 is in year 3, doesn't need to be discounted for 3 years by 1.17? |

synner |
yeah, i think zhaojiang's right |

RealEduardo |
To review in the calculator how to calculate the indefinitely cash flows. |

haarlemmer |
Hey, if the answers are like these in the exam, the answer is easy to be found out. hehe. |

cwrolfe |
Kunam, regarding 3 yr discount...the PV AT YEAR ZERO WITH FIRST PAYMENT AT T=1 of a perpetuity is the annuity pymt. divided by the int. rate. So if you back up from t=3 to t=2 in this problem to calc the pv of the perpetuity with its first payment at t=3, you've effectively already discounted one period and therefore only need discount that PV two more periods. |

ashok1959 |
can any one tell me how to calculate NPV for indefinit cashflow in BA II plus for this question. |

thekapila |
indefinately cash flow = perpetuity = CF/R = 300,000/.17 Now with TVM this value is at end of year 2 so PV of this start of year 1 = pepetuity/1.17*1.17 |

Khadria |
Perpetuity: PV = A/r |

julescruis |
Thanks for your explanations, I first dicounted the 1,7 million for three periods instead of two. Making so many mistakes, damn... |

hannovanwyk |
You cant go wrong with a time line! works for me every time! |

clafleur |
you can use the CF function on the BAII, make cf1=100,000 F01=1, cf2=250,000 F02=1, then make cf3=3000 F03=1000, this will effectively make the last CF a perpetuity |

joantym |
thanks clafleur for the guide on how to use the BAII... |

mavend |
Does anyone know how to calculate it in hp12c? |

Beret |
See example 15 (p. 196 Vol. 1) of the curriculum for a perpetuity starting in the future. |

fedha |
Good question |

miiyeung |
Wow, thanks clafleur! BAII: cf0= -1500,000 cf1= 100,000 F01=1, cf2= 250,000 F02=1, cf3=3 00,000 F03=1000 FO3 is the frequency of the cash inflow; the amount occurs as a perpetuity and so will count the next 1000 years. |

DonAnd |
clafleur you are my hero...way to go! I hope I remember that when under pressure in the exam. Thank you! |

bantoo |
I did not not understand the solution. Can anybody explain it in detailed concept. I will be grateful. |

erinelize |
I did the same thing as clafleur and only used 100 for F03 and still got the same answer..so as long as you choose a big enough number it's treated the same as a perpetuity. Probably best to use 1000 just to be safe :) |

Cozma |
Perpetuity... |

tawastar |
CFo = -1,500,000 C01 = 100,000 C02 =(300,000/.17)+250,000 = 2,014,705.88 I = 17 CPT NPV...57,240.03 |

SergoUA |
tawastar, thank you. This is the very quick calculation |

moneyguy |
Very good tips with the BAII, everybody. The perpetuity calculation with 1000 for F03 is great! |

johntan1979 |
Or if you want to be safe, just in case the answers are very close (not rounded), you can just use 2000 years, since the world's oldest companies has been around for only 1851 years (e.g. Reuters, Western Union) as of 2012. |

long2012 |
BA II Plus can use Frequency until 9,999. So for the actual answer you can use F03=9,999. |

jonan203 |
mavend: 1,500,000 <chs><g><CFo> 100,000 <g><CFj> 300,000 <enter> .17 <divide> 250,000 <plus><g><CFj> 2 <n> 17 <i><f><NPV> = $57,240 |