QUESTION THREE Investment Decision Criteria/Capital Budgeting
You are a top finance graduate from Federation University. Your friend Alex is a management graduate and therefore has little chance of finding a job outside the fast-food industry. Luckily for him, Alex's rich uncle has left him $20 million in his will. Having been a management student, Alex partied while you studied. In fact, he took no courses in finance and thus knows nothing about investment. In a drunken stupor, late one Saturday night Alex watched an interview with the Guru Yogi Berra. The Guru claims material wealth lies beneath the ground in Dromana. It is clear from the tone of the interview, the title of the documentary was "An interview with a crackpot," that the interviewer and the "experts" on the show think the Guru is insane. However, Alex believes in the Guru because his management training taught him to believe in gurus (Peter Drucker, for example). Alex decides to use his new-found fortune to prove the Guru correct, making himself one of the richest people in Australia in the process!
Alex knows you have superior intellect (otherwise you wouldn't be in Finance) and asks you to work out the details. After some discreet investigation you find the homes and land can be purchased for $15 million In addition, the local council insist on a $4 million fee for defacing the views from the city. Finally, it costs $1 million to lease the mining equipment.
You and Alex meet with the Guru and after several hours of meditation the Guru provides you with estimated annual after-tax cash-flows. These cash-flows are in millions and are provided to you below in table 2-1. Alex thinks the cash-flows sound fantastic (compared to a career flipping burgers. Who wouldn't), you however decide to check the numbers using what you have learned in Finance. You believe the project is very risky and therefore in consultation with Westpac Bank Risk Management team decide to use a discount rate of 23%. Should Alex invest his fortune based on the crackpot's ideas? a) Calculate the Net Present Value and the Internal Rate of Return. Would your decision change if you used a discount rate of b) 18% c) 10%.
Table 2-1 Projected Cash Flows
Year 1 Projected Cashflow $1,500,000 Year 11 Projected Cash]ion 52,500,000 Year 2 $3,278,000 Year 12 $2,500,000 Year 3 $5,000,000 Year 13 $2,500,000 Year 4 $6,450,000 Year 14 $2,500,000 Year 5 $2,500,000 Year 15 $2,500,000 Year 6 $2,500,000 Year 16 $2,500,000 Year 7 $2,500,000 Year 17 $2,500,000 Year 8 $2,500,000 Year 18 $2,500,000 Year 9 $2,500,000 Year 19 $2,500,000 Year 10 $2,500,000 Year 20 $2,500,000