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    Capital Budgeting

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    1. Hilton Hotels is planning to open a new hotel in Dubai at an initial investment of $20 million. It expects positive cash flows of $4 million a year at the end of each of the next 20 years. The project's cost of capital is 15%.

    A. What is the project's net present value?
    B. In year 1, Hilton Hotels will know if the government of Dubai will impose a large hotel tax. There is a 50 percent chance that it will not. If the tax is imposed, the yearly cash flows will only be $2.5 million; if not, the yearly cash flows will be $5.5 million. The initial investment of $20 million will be the same today or 1 year from now. Should Hilton Hotels go ahead with the project today or should it wait a year before deciding?

    2. Provided below is information on a stock and its call option:

    The price of the stock is $40.
    The strike price is $40.
    The option matures in 3 months (t=0.25).
    The standard deviation of the stock's returns is 0.40 and the variance is 0.16.
    The risk-free rate is 6 percent.

    An analyst is able to calculate some other necessary components of the Black-Scholes model:

    d1 = 0.175
    d2 = -0.025
    N(d1) = 0.56946
    N(d2) = 0.49003

    A. Using the Black-Scholes model, what is the value of the call option?
    B. What is the value of a put option written on the stock with the same exercise price and expiration date as the call option?

    3. A certain project has a cost of $52,125, its expected net cash inflows are $12,000 per year for 8 years, and its cost of capital is 12 percent.

    A. Compute its discounted payback period.
    B. Compute its NPV.
    C. Compute its IRR.
    D. Compute its MIRR.

    4. There are 2 alternative projects. Project 1 has an expected life of 5 years, will cost $100 million, and will produce net cash flows of $30 million per year. Project 2 has a life of 10 years, will cost $132 million, and will produce net cash flows of $25 million per year. The company needs to plan for 10 years. Its cost of capital is 12 percent.

    A. By how much would the value of the firm increase if it accepted the better project?

    5. California Trucking Company purchased a new truck. It costs $22,500 and it is expected to generate net after-tax operating cash flows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The expected salvage values after tax adjustments are provided below. The California Trucking Company's cost of capital is 10 percent.

    Year Annual Operating Cash Flow Salvage Value
    0 ($22,500) $22,500
    1 $6,250 $17,500
    2 $6,250 $14,000
    3 $6,250 $11,000
    4 $6,250 $5,000
    5 $6,250 0

    A. Should California Trucking Company operate the truck until the end of its 5-year physical life, or, if not, what is its optimal economic life?

    6. D.C. Company is assessing a proposed acquisition of a new machine Its base price is $70,000 and it would cost $15,000 to modify it for special use. It will be depreciated at the rate of 33% on the 1st year, 45% on the 2nd year, and 15% on the 3rd year. It will be sold after 3 years for $30,000. Its use will require an increase in net working capital of $4,000. It will have no effect on revenues however it is expected to save the company $25,000 per year in before-tax operating costs, mainly labor. The company's marginal tax rate is 40 percent.

    A. What is the net cost of the machine? (What is the Year 0 net cash flow?)
    B. What are the net operating cash flows in Years 1, 2, and 3?
    C. What is the additional (nonoperating) cash flow in Year 3?
    D. If the project's cost of capital is 10 percent, should the machine be bought?

    7. Intel Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semi-annually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Its beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. It is a constant-growth company which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The company's marginal tax rate is 40 percent.

    A. What is its component cost of debt?
    B. What is its cost of preferred stock?
    C. What is its cost of common stock (rs) using the CAPM approach?
    D. What is its cost of common stock (rs) using the DCF approach?
    E. What is its WACC? (For cost of common stock, use either of your solutions to C. or D.?

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    Solution Summary

    The solution explains various problems relating to capital budgeting