# Firm's Capital Investment Evaluation

You are heading up your firm's capital investment evaluation efforts. Currently, the capital investment group is deliberating over the three investment proposals below. They are not mutually exclusive. Your company uses a 12% annual rate to discount cash flows for NPV. The following table presents the costs of each investment (negative values in time zero) and the expected cash flows for each investment each year.

time period Investment A Investment B Investment C

0 (today) -500 -2000 -500

1 200 400 300

2 300 500 200

3 400 800 100

4 500 900

5 1000

1. Calculate the payback period for each investment.

2. Calculate the IRR for each investment.

3. Calculate the NPV for each investment.

4. Which investments, if any, would you recommend to your firm? Why?

5. Do you see any possible sources of distortion in the evaluation results above for these projects? Explain.

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#### Solution Summary

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Finance Management

1. Spencer Inc. has the following information for the current year: Net income = $600; Net operating profit after taxes (NOPAT) = $500; Total assets = $4,000; Short-term investments = $500; Stockholders equity = $2,000; Debt = $1,000; and Total net operating capital = $2500. If Spencer's cost of capital is 10%, what is its Economic value added (EVA)?

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1. Spencer Inc. has the following information for the current year: Net income = $600; Net operating profit after taxes (NOPAT) = $500; Total assets = $4,000; Short-term investments = $500; Stockholders equity = $2,000; Debt = $1,000; and Total net operating capital = $2500. If Spencer's cost of capital is 10%, what is its Economic value added (EVA)?

Some returns data for the market and for Countercyclical Corp. are given below:

Year Market Countercyclical

Year 1 -2.0% 8.0%

Year 2 12.0 3.0

Year 3 -8.0 18.0

Year 4 21.0 -7.0

The required return on the market is 14 percent, and the risk-free rate is 8 percent. What is the required return on Countercyclical Corp., according to CAPM/SML theory?

2. Here are the expected returns on two stocks:

Returns

Probability X Y

0.1 -20% 10%

0.8 20 15

0.1 40 20

If you form a 50-50 portfolio of the two stocks, what is the portfolio's standard deviation?

3. Rollins 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 semiannually, 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. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent.

a) What is Rollins' component cost of debt?

b) What is Rollins' cost of preferred stock?

c) What is Rollins' cost of common stock (rs) using the CAPM approach?

d) What is the firm's cost of common stock (rs) using the DCF approach?

e) What is the firm's cost of common stock (rs) using the DCF approach?

f) What is Rollins' cost of common stock using the bond-yield-plus-risk-premium approach?

4. Florida Phosphate is considering a project which involves opening a new mine at a cost of $10,000,000 at t = 0. The project is expected to have operating cash flows of $5,000,000 at the end of each of the next 4 years. However, the facility will have to be repaired at a cost of $6,000,000 at the end of the second year. Thus, at the end of Year 2 there will be a $5,000,000 operating cash inflow and an outflow of -$6,000,000 for repairs. The company's cost of capital is 15 percent. What is the difference between the project's MIRR and its regular IRR?

5. Joe and Jane are interested in saving money to put their two children, John and Susy through college. John is currently 12 years old and will enter college in six years. Susy is 10 years old and will enter college in 8 years. Both children plan to finish college in four years.

College costs are currently $15,000 a year (per child), and are expected to increase at 5 percent a year for the foreseeable future. All college costs are paid at the beginning of the school year. Up until now, Joe and Jane have saved nothing but they expect to receive $25,000 from a favorite uncle in three years.

To provide for the additional funds that are needed, they expect to make 12 equal payments at the beginning of each of the next twelve years--the first payment will be made today and the final payment will be made on Susy's 21st birthday (which is also the day that the last payment must be made to the college). If all funds are invested in a stock fund which is expected to earn 12 percent, how large should each of the annual contributions be?

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