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1) you are considering opening a new plant. The plant will cost $100 upfront and will take a year to build.
after that, it is expected to produce profits of $30 million at the end of every year of production.
The cash flows are expected to last forever.
Calculate the NPV of this investment opportunity if your cost of capital is 8%.
should you make the investment?
Calculate the IRR and use it to determine the maximum deviation allowable in the cost of the capital estimate to leave the decision unchanged.
2)Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million.
The product is expected to generate profits of $1million per year for ten years. The company will have to provide product support that will cost $100,000 per year in perpetuity.
Assume all profits and expenses occur at the end of the year.
a) what is the NPV of this investment if cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rates of 2% and 11%.
b) How many IRRs does this investment opportunity have?
c) What does the IRR rule indicate about this investment?
3) You work for an outdoor play structure mftg company and are trying to decide between 2 projects.
Year-End Cash Flows in ($) thousands
Project 0 1 2 IRR
Playhouse -30 15 20 10.40%
Fort -80 39 52 8.60%
You can undertake only 1 project. If your cost of capital is 8%, use the incremental IRR rule to make the correct decision.
Home Builder Supply operates seven retail outlets in Georgia and South Carolina. Management is contemplationg building an eighth retail store across town from its most succesful retail outlet
The company already owns the land for this store, which currently has an abandoned warehouse located on it.
Last month, the marketing dept spent $10,000 on market research to determine the extent of customer demand for new store. Now Home Builder Supply must decide whether to build and open new store.
Which of the following should be included as part of the incremental earnings for the proposed new retail store?
a) cost of land where store will be located
b)cost of demolishing abandoned warehouse and clearing lot
c)loss of sales in the existing retail outlet, if customers who previously drove across town to shope at existing outlet become customers of new store instead.
d)the $10,000 in market research spent to evaluate customer demand
e)Construction costs for new store
f)Value of land if sold
g)Interest expense on debt borrowed to pay construction costs.
5)Elmdale Enteprises is deciding whether to expand its production facilities Although long term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in millions of $)
Year 1 Year 2
Revenues 125 160
Cost of goods and operatin expenses other than depreciation 40 60
Depreciation 25 36
Increase in working capital 5 8
Capital expenditures 30 40
Marginal corporate tax rate 35% 35%
a)What are the incremental earnings for this project for years 1 and 2?
b) What are the free cash flows for this project for first 2 years?
Markov Mftg recently spent $15 million to purchase some equipment used in the manufacture of disk drives.
The firm expects that this equipment will have a useful life of 5 years and its marginal corporate tax rate is 35%.
The company pans to use straight line depreciation.
a)What is the annual depreciation expense associated with this equipment?
b)What is the annual depreciation tax yield?
c) Rather than straight-line, supposes Markov uses MACRS depreciation method for five-year property.
Calculate the depreciation tax shield each year for this eqpmt under this accerelated depreciation schedule.
d) If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected
to remain constant ,which should it choose? Why?
The solution explains some questions relating to capital budgeting