E425 Review

Problem 3: (Technical Information Systems)

TIS is planning to build a new plant to manufacture a small high performance PC.
Information:
Capacity: 20,000 units per year.
Capacity cost: () = 4, 000, where is quantity of PC to produce.
Production cost: () = 2, 000.
Demand function: = 10, 000 .2.
The project will generate cash flows for a 5 year period.
Tax rate = 50%.
Moreover, project has a beta = 1.6. = .12, = .17.
Question:
(a) what is the discount rate for the project?
(b) What size plant should TIS build if = 0?
(c) What is the range of such that the proposed project have a nonnegative NPV?
Solution:
(a) Use the formula = + ( ) and the vales of , , and , we have = .2.
(b) Optimal size * maximizes the net present value of the project.
NCF:
= (1 tax) (Revenue - Cost) + tax capacity cost per year
= (1 50%)((10, 000 .2) 2000) + 50%( 4000
).
5
NPV:
= () +

=1

1.2

= () + (

1
).

1.2
=1

1
1 1
1

=
= 2.99.

5
1.2
.2
.2
(1.2)
=1

Therefore,
= 9158.7 1.4953 .29906 2 .

(1)

When = 0, = 9158.7 .29906 2 . Derivative of NPV with respect to y is

9158.7 2 (.29906). When derivative is 0, = 15312 < 20, 000. In other words, a
plant with capacity = 15312 gives higher return (or NPV) for the firm. The firm should
build a smaller plant.
(c) In the proposed project, = 20, 000. By equation (1), 0 if and only if
2125.

Problem 4: (Olmos Rock)

Information:
OR estimates that entering in to the longterm contract will increase their annual net operating income by $1, 500, 000. If enters the contract,
- New equipment: costs $800, 000; and will have to be replaced every 5 years.
- Old (or existing) equipment: costs $800, 000; it has to be replaced at the end of year 3
rather than year 4; and is has to be replaced every 5 years instead of 6 years.
Moreover, opportunity cost of capital = 10%.
Question:
what is the NPV for the project?
Solution:
First, calculate the additional cost for the old equipment.
Without the contract, the existing equipment costs $800, 000 every 6 years, which is equivalent to cost $183690 every year. $183690 is got from the equation below:
6 =

800, 000
= 183690.
.11 1.11 6

1
.1

With the contract, the existing equipment costs $800, 000 every 5 years, which is equivalent
to cost $211040 every year. $211040 is got from the equation below:
5 =

800, 000
= 211040.
.11 1.11 5

1
.1

Think about the picture below, the two processes generate the same cost. Therefore, the
cost generated by replacing the old equipment more frequently is:
wear and tear =

1 183690
1 211040

= 330, 950.
3
1.1
.1
1.14 .1

Second, cost by using the new equipment: new =

211040
.1

= 2, 110, 400.

Therefore, the present value of the additional cost: wear and tear + new = 330, 950.
Present value of increase in net operating income: 1,500,000
= 15, 000, 000. Therefore, the
.1
net present value of the project: = 15, 000, 000 330, 950 = 12, 559, 000.
Additional question:
What if the cost for the old equipment is $700, 000 instead of $800, 000?

Reference: Financial Economics 425 Some Capital Budgeting Problems, by Frank Page.