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Financial Management: Net Present Value Analysis

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Suppose a company has hired you to estimate the cash flows arising from a proposed capital project by replacing old equipment with a $0 market value and a book value of $6000, and you have been handed the relevant data below. The project being considered has a 5-year tax life, and at the end of year 5 the asset will be worthless (i.e. salvage value =0). The CFO suggests that you depreciate the asset by using the straight-line method over the 5 year life of the project. Revenues and other operating costs are as noted below, and will be constant over the period.

Equipment cost: $150,000; Book value of old equipment: $6000
Delivery and installation cost of equipment and remove old equipment: $50,000;
Straight-line depreciation rate: 20% (5-year); Sales revenue each year: $100,000
Operating costs (excluding depreciation): $30,000; Tax rate: 40%

(a) What are annual cash flows for the next five years? Hint: find CF0 to CF5
(b) Suppose CFO will borrow 50% of capital from a bank with 10% interest, and 50% of capital through equity with 22% of require rate of return. What is the cost of capital for this project?
(c) What is the net present value of this project and should you convince the CFO to accept or reject the new equipment?
(d). If the firm's CEO want to use IRR to value the project, will IRR has the same suggestion as NPV? (please find IRR, and explain what it means)

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Solution Summary

A net present value analysis for a company with data provided is given in Excel .

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In the next two years, a large municipal gas company must begin constructing new gas storage facilities to accommodate the Federal Energy Regulatory Commission's Order 636 deregulating the gas industry. The vice-president in charge of the new project believes there are two options. One option is an underground deep storage facility (UDSF) and the other is a liquified natural gas facility (LNGF). The vice-president has developed a project selection model and will use it in presenting the project to the president. For the models she has gathered the following information:

Initial Cost Operating Cost/Cu. Ft. Expected Life Salvage Value
UDSF $10,000,000 $0.004 20 years 10%

LNGF 25,000,000 0.002 15 5

Since the vice-president's background is in finance, she believes the best model to use is a financial one, net present value analysis.

Questions: Would you use this model? Why or why not?

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