Finance 100 Problem Set Capital Budgeting

1. Consider the following capital budgeting problem. The following two machines are mutually exclusive and the rm would keep reinvesting in whatever machine it buys. Machine A would be reinvested every 4 years, machine B every 3 years. The cash ows 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 0 -80 1 50 2 50 3 50 4 25 Machine B -100 60 60 60 -

1.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 ts current technology, whereas machine B needs a one-time retooling for the company. These one-o installation costs would be $10,000 today. What is the optimal investment decision now?

1.c Suppose the rm 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 ows for the old machine are: Year 1 2 3 Cashow 50 20 0

1.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 rm $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 rm 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 companys oce 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 rm is willing to pay for the machine? [Hint: the price of the machine determines the level of depreciation and therefore the taxes that the rm pays]. 4. A corporation is considering purchasing a machine that has an 8-year life and will save the rm $4,500 per year in net operating costs. The machine would be depreciated on a straight-line basis to a zero salvage value. The rm has a 34% tax rate and a 12% p.a. required rate of return on this project. 2

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 rm buy the machine or lease it? 4.c If the machine costs $10,000, what is the maximum lease payment the rm 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 rst 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 companys revenues are unaected by the replacement policy and that the rm 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 eects. 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 ows 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 projects internal rate of return (IRR), should the rms managers invest in this project? Is the IRR criterion the correct decision rule in this case?

6.b After observing the managers decision, a shrewd businessman oers the managers of Cement Inc. the following modied project. The businessman oers that the rm 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 oer, the businessman proposes that the rm pay him $1,100,000 in year 3. Cement Inc.s CFO argues that according to the IRR criterion the proposal is protable 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 rm? 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 ve years ad innitum. TTC has not yet decided when to initiate the rst of these leasing agreements. TTC currently has a eet of existing trucks that have 3 years of useful life remaining. At present, TTCs truck eet could be sold for $3,000,000. In 3 years time, the eet salvage value will be $600,000. Current book value for the truck eet is $2,400,000 and the eet is being depreciated on a straight-line basis. Maintaining the truck eet 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 rm will generate $2,100,000 in revenue and $500,000 in expenses (apart from truck eet related expenses) this year and each following year. The companys 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 rm as a whole. Also assume that their tax rate is 34%. Should TTC immediately initiate the leasing agreement and sell their current eet of trucks or should TTC continue using their existing eet for 3 more years and then initiate the leasing agreement?

8. Gadgets, Inc. needs to allocate this years 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 ve years. The required rate of return for both projects is identical to the rms cost of capital of 15%. Their tax rate is 34%. Year Investment Revenue Expenses Year Investment Revenue Expenses 0 $1,300.00 0 $1,200.00 New Retail Outlet 1 2 3 4 $2,315.25 $1,273.39 4 $1,736.44 $926.10 5 $2,431.01 $1,337.06 5 $1,823.26 $972.41

$2,000.00 $2,100.00 $2,205.00 $1,100.00 $1,155.00 $1,212.75 Product Enhancement 1 2 3 $1,500.00 $1,575.00 $1,653.75 $800.00 $840.00 $882.00 (All gures in thousands)

8.a Calculate net cash ows 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.

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 protable 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 protable. This uncertainty will be resolved over the next ve years. Under (2) the plant costs more, but produces the current product more eciently for a longer period of time. Since the rm hasnt 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 rm will be able to produce the second generation of the product if it should be protable to do so. Production of the second generation product would require some minor additional capital expenditures in the plant from (2) in ve years. Under (1), the rm 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 ows generated by each plant option are listed below. The companys 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 ows below relate solely to production of the current product. The competitive situation surrounding technology advances over the ve-year period is highly uncertain, thereby making reliable estimation extremely dicult. Year Plant 1 Plant 2 0 -3,322 -4,286.7 After Tax Cash Flows 1 2 3 4 1,776.5 1,397 996.6 554.4 772.3 1,236.4 1,762.2 1,549.9 (All gures in thousands) 5 145.2 1,217.7 6 42.9 666.6 7 13.2 236.5

Should MI prefer plant (1) or plant (2) or is it indierent if they only pay attention to the cash ows from the rst generation product? Could your answer be aected by the fact that plant (2) may be available for future 6

product improvements, and if so, how?