# 6 Finance Problems: Calculate WACC, NPV, cash flow, EAA, IRR, abandonment value

Hilliard Corp. wishes to calculate its weighted average cost of capital. The firm's CFO has gathered the following information:
? The firm's long-term bonds currently offer a yield to maturity of 8%.
? The company's stock price is currently at \$32 per share.
? The most recent dividend at t= 0 was \$2 per share.
? The dividend is expected to grow at a constant rate of 6% a year.
? The firm pays a 10% flotation cost whenever it issues new common stock.
? The firm's target capital structure is 75% equity and 25% debt.
? The firm's tax rate is 40
? The firm has no retained earnings available so it anticipates issuing new common stock.
What is the firm's weighted average cost of capital?

Seattle Co., Inc. has an investment opportunity that will yield end of year cash flows of \$30,000 per year in years 1 through 4, \$35,000 in years 5 though 9, and \$40,000 in year 10. The investment will cost \$150,000 today and the firm's cost of capital is 10%. What is the NPV? Show all work.

Given the following information, what is the required cash outflow associated with the acquisition of a new machine; that is, in a project analysis, what is the cash outflow at t = 0?

Purchase price of new machine \$8,000
Installation charge 2,000
Market value of old machine 2,000
Book value of old machine 1,000
Inventory decrease if new machine
Is installed 1,000
Accounts payable increase if new
Machine is installed 500
Tax rate 35%
Cost of capital 15%

The Mike & Laurie Consulting Group Inc. is trying to decide which computer system to purchase. They can purchase state-of-the-art equipment for \$20,000, which they expect to generate cash flows of \$6,000 at the end of each of the next 6 years. Alternatively, they can spend \$12,000 for equipment that can be used for 3 years and generates cash flows of \$6,000 at the end of each year. If the company's cost of capital is 10 percent and both "projects" can be repeated indefinitely, then what is the equivalent annual annuity (EAA) of both projects?

Mom's Cookies Inc. is considering the purchase of a new cookie oven. The original cost of the old oven was \$30,000; it is now 5 years old, and it has a current market value of \$13,333.33. The old oven is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of \$15,000 and an annual depreciation expense of \$3,000. The old oven can be used for 6 more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new oven whose cost is \$25,000, whose estimated salvage value is zero and with a useful life of 6 years. Expected before-tax cash savings from the new oven are \$4,000 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a 5-year life, and the cost of capital is 10 percent. Assume a 40 percent tax rate. What is the net present value of the new oven?
The five year depreciation rates are: 20% for first year, 32% for the second year, 19% for the third year, 12% for the fourth year, 11% for the fifth and 6% for the final year.

Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo shirts. Process S has a cost of \$8,000 and will produce net cash flows of \$5,000 per year for 2 years. Process L will cost \$11,500 and will produce cash flows of \$4,000 per year for 4 years. The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's cost of capital is 10 percent, what is the NPV and IRR of each project? Which project should be accepted?

Oklahoma Instruments (OI) is considering a project that has an up-front cost of \$250,000. The project's subsequent cash flows critically depend on whether its products become the industry standard. There is a 50 percent chance that the products will become the industry standard, in which case the project's expected cash flows will be \$110,000 at the end of each of the next five years. There is a 50 percent chance that the products will not become the industry standard, in which case the project's expected cash flows will be \$25,000 at the end of each of the next five years. Assume that the cost of capital is 12 percent.

A. Based on this information, what is the project's expected net present value?

B. Now assume that one year from now OI will know if its products will have become the industry standard. Also assume that after receiving the cash flows at t = 1, the company has the option to abandon the project. If it abandons the project it will receive an additional \$100,000 at t = 1, but will no longer receive any cash flows after t = 1. Assume that the abandonment option does not affect the cost of capital. What is the estimated value of the abandonment option?

#### Solution Summary

The solutions to the problems are carefully detailed with explanations as necessary for better understanding.