Finance 100 Problem Set Capital Budgeting

Transcription

1 Finance 100 Problem Set Capital Budgeting 1. Consider the following capital budgeting problem. The following two machines are mutually exclusive and the firm would keep reinvesting in whatever machine it buys. Machine A would be reinvested every 4 years, machine B every 3 years. The cash flows associated with each machine are tabulated as follows; all numbers are in thousand dollars; the relevant discount rate is 10% for both machines. Year Machine A Machine B a Which of the two machines is the better investment project? Analyze the question under the assumption that whatever machine the company buys has to be reinvested in perpetuity. 1.b Suppose A fits current technology, whereas machine B needs a one-time retooling for the company. These one-off installation costs would be $10,000 today. What is the optimal investment decision now? 1

2 1.c Suppose the firm has an old machine in place that would serve for another two years. They can postpone investing in either machine A or B and keep using this machine. When should they stop using the old machine? Cash flows for the old machine are: Year Cashflow d Suppose the investment opportunity described above lasts only for 24 years. Recalculate your decision rule for questions 1.a and 1.b. What is the NPV of the optimal investment policy now? 2. A corporation is considering purchasing a machine that has an expected eight-year life and will generate for the firm $11,000 per year in net operating income before taxes. The machine will be depreciated using the straight-line method to its anticipated salvage value of $12,000. The firm has a 34% marginal tax rate and the required return for this project is 12% p.a. If the machine costs $60,000, should it be purchased? 3. Another machine salesman comes by the company s office and says that he is willing to negotiate the purchase price of the machine described in the previous question. What is the maximum price the firm is willing to pay for the machine? [Hint: the price of the machine determines the level of depreciation and therefore the taxes that the firm pays]. 4. A corporation is considering purchasing a machine that has an 8-year life and will save the firm $4,500 per year in net operating costs. The machine would be depreciated on a straight-line basis to a zero salvage value. The firm has a 34% tax rate and a 12% p.a. required rate of return on this project. 2

3 4.a If the machine costs $25,000, should it be purchased? 4.b If the machine can be leased for $4,000 per year payable at the end of each year, should the firm buy the machine or lease it? 4.c If the machine costs $10,000, what is the maximum lease payment the firm would be willing to pay if it was to consider a leasing alternative? 5. A company is trying to determine an optimal replacement policy for a piece of its equipment. The cost of the machine is $15,000 and the annual maintenance costs are $1,000 in the first year, $2,000 in the second year and $3,000 in the third year. Anticipated salvage values are $6,000, $3,000 and $0 at the end of years 1 through 3, respectively. Assume that the company s revenues are unaffected by the replacement policy and that the firm has a 34% tax rate, a 12% p.a. required return on this project and uses a straight-line depreciation. Should the equipment be replaced every year, every second year, or every third year? Be sure to explicitly consider the depreciation and tax effects. 6. Cement Inc. is considering an investment opportunity that requires an initial outlay equal to $575,000. In years 1 and 2 the net cash flows are expected to equal $500,000. The required rate of return is 25% p.a. 6.a Given that the Cement Inc. s criterion whether to invest or not is the project s internal rate of return (IRR), should the firm s managers invest in this project? Is the IRR criterion the correct decision rule in this case? 3

4 6.b After observing the managers decision, a shrewd businessman offers the managers of Cement Inc. the following modified project. The businessman offers that the firm will pay the initial outlay $575,000 only in year 2 and receive the $500,000 in years 0 and 1. As a compensation for receiving this offer, the businessman proposes that the firm pay him $1,100,000 in year 3. Cement Inc. s CFO argues that according to the IRR criterion the proposal is profitable since the 25% required rate of return is lower then the new IRR for this investment. Is the CFO correct in his argument that the required rate of return is lower then the IRR? Does this decision rule lead to optimal investment by the firm? 7. Transland Trucking Corp. (TTC) has decided to enter into a series of 5-year lease agreements with GE Corp. to provide and maintain equipment for its global transport needs. These agreements will be rolled over every five years ad infinitum. TTC has not yet decided when to initiate the first of these leasing agreements. TTC currently has a fleet of existing trucks that have 3 years of useful life remaining. At present, TTC s truck fleet could be sold for $3,000,000. In 3 years time, the fleet salvage value will be $600,000. Current book value for the truck fleet is $2,400,000 and the fleet is being depreciated on a straight-line basis. Maintaining the truck fleet involves $150,000 worth of expenses per year. Under the leasing agreement, GE provides and maintains the equipment for a fee of $1,000,000 per annum. Regardless of the timing of the leasing decision, the firm will generate $2,100,000 in revenue and $500,000 in expenses (apart from truck fleet related expenses) this year and each following year. The company s cost of capital is 16% (required rate of return). Assume that this project has a level of risk which is identical to the risk of the firm as a whole. Also assume that their tax rate is 34%. Should TTC immediately initiate the leasing agreement and sell their current fleet of trucks or should TTC continue using their existing fleet for 3 more years and then initiate the leasing agreement? 4

5 8. Gadgets, Inc. needs to allocate this year s capital expenditure budget to either construction of a new retail outlet or investment in product enhancement. The marketing department has prepared estimates of the predicted increase in sales resulting from each project. The required investment for each project is known and will be depreciated over five years. The required rate of return for both projects is identical to the firm s cost of capital of 15%. Their tax rate is 34%. New Retail Outlet Year Investment $1, Revenue - $2, $2, $2, $2, $2, Expenses - $1, $1, $1, $1, $1, Product Enhancement Year Investment $1, Revenue - $1, $1, $1, $1, $1, Expenses - $ $ $ $ $ (All figures in thousands) 8.a Calculate net cash flows for each project 8.b Calculate the NPV of each project. Which project should you choose? 8.c Graph the NPV of project 1 and project 2 (y-axis) against a range of discount rates from 0% to 50% in 5% increments (x-axis). 8.d Is the IRR the appropriate criterion in this case. 5

6 9. Microprocessor Inc. (MI) has decided to build a new plant in order to take advantage of overwhelming demand for their current microprocessor product. MI needs to decide whether to build the plant (1) solely to produce their current product or if they should engineer the plant so that (2) it will also be able to produce the next generation of their product if it becomes profitable to do so. That is, there is some uncertainty about whether this type of technology will be popular in the marketplace. If it does become popular, a second generation of the product will be profitable. This uncertainty will be resolved over the next five years. Under (2) the plant costs more, but produces the current product more efficiently for a longer period of time. Since the firm hasn t used this type of plant before there are extra training and teething costs expected in the early years of its life. Moreover, under (2), the firm will be able to produce the second generation of the product if it should be profitable to do so. Production of the second generation product would require some minor additional capital expenditures in the plant from (2) in five years. Under (1), the firm will be unable to enter the market for the second generation of the product because the costs of completely re-engineering the plant to enter the second generation market will be prohibitively high. The expected net cash flows generated by each plant option are listed below. The company s cost of capital for this type of project is 15%. Note that neither the potential investment in a plant upgrade for the second generation product nor the potential revenues from this product have been included in the earnings estimates for plant (2). That is, for both plant options, the cash flows below relate solely to production of the current product. The competitive situation surrounding technology advances over the five-year period is highly uncertain, thereby making reliable estimation extremely difficult. After Tax Cash Flows Year Plant 1-3,322 1, , Plant 2-4, , , , , (All figures in thousands) Should MI prefer plant (1) or plant (2) or is it indifferent if they only pay attention to the cash flows from the first generation product? Could your answer be affected by the fact that plant (2) may be available for future 6

7 product improvements, and if so, how? 7