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# Present Value and Investment Decisions

I have attached two excel files with 3 question on each of them.

Kindly solve the 6 questions.

Thank you !

Mrs. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for \$400,000. Of this sum, \$50,000 is described by the supplier as an installation cost. Mrs. Potts does not know whether the Internal Revenue Service (IRS) will permit the company to treat this cost as a tax- deductible current expense or as a capital investment. In the latter case, the company could depreciate the \$50,000 using the 5-year MACRS tax depreciation schedule. How will the IRS's decision affect the after-tax cost of the kiln? The tax rate is 35 percent and the opportunity cost of capital is 5 percent.

A project requires an initial investment of \$100,000 and is expected to produce a cash inflow before
tax of \$26,000 per year for five years. Company A has substantial accumulated tax losses and is
unlikely to pay taxes in the foreseeable future. Company B pays corporate taxes at a rate of 35 percent and
can depreciate the investment for tax purposes using the five-year tax depreciation schedule.

Suppose the opportunity cost of capital is 8 percent. Ignore inflation.

a)      Calculate the project NPV for each company.

b)      What is the IRR of the after-tax cash flows for each company?
What does comparison of the IRRs suggest is the effective corporate tax rate?

Reliable Electric is considering a proposal to manufacture a new type of industrial electric
motor which would replace most of its existing product line. A research breakthrough has
given Reliable a two year lead on its competitors. The project proposal is summarized in Table 6.7. (Attached on next sheet)

a)  Read the notes to the table carefully. Which entries make sense? Which do not? Why or why not?

b)       What additional information would you need to construct a version of Table 6.7 that makes sense?

c)       Construct such a table and recalculate NPV. Make additional assumptions as necessary.

A machine costs \$380,000 and is expected to produce the following cash flows:

Year 1 2 3 4 5 6 7 8 9 10
Cash Flows (000s)
\$50 \$57 \$75 \$80 \$85 \$92 \$92 \$80 \$68 \$50

If the cost of capital is 12 percent, what is the machine's NPV?

Question 21: The present value of lottery winnings

In August, 1994, The Wall Street Journal reported that the winner of the Massachusetts
State Lottery prize had the misfortune to be both bankrupt and in prison for fraud. The
prize was \$9,420,713, to be paid in 19 equal annual installments. (There were 20
court judge ruled that the prize should be sold off to the highest bidder and the proceeds
used to pay off the creditors.

a)     If the interest rate was 8 percent, how much would you have been prepared
to bid for the prize?

b)     Enhance Reinsurance Company was reported to have offered \$4.2 million.
Find the return that the company was looking for.

Question 22: Evaluating a mortgage

A mortgage requires you to pay \$70,000 at the end of each of the next eight years. The interest rate is 8 percent.

a)     What is the present value of these payments?
b)     Calculate for each year the loan balance that remains outstanding,
the interest payment on the loan and the reduction in the loan balance.

#### Solution Summary

This solution shows step-by-step calculations in calculating present values of scenarios and gives recommendations on making investment decisions with the net present value rule.

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