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Capital Budgeting

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1) Tom Thurlow wants to buy a boat but is short of cash. Two alternatives are available: Tom can accept \$2,000 per year from his brother for partial ownership in the boat, or he can earn money by renting the boat to others. Rental income would be \$2,500 per year. Under either alternative, the boat will last eight years. If Tom rents the boat out, he will have to pay \$3,000 to overhaul the engine at the end of the fourth year.

Which alternative should Tom select, assuming that the cost of capital is 12% and that only quantitative considerations are involved?

2) Net Present Value Used to Rank Alternatives
Taglioni's Pizza Company has to choose a new delivery car from among three alternatives. Assume that gasoline costs \$1.30 per gallon and that the firm's cost of capital is 12%. The car will be driven 12,000 miles per year.

Car 1 Car 2 Car 3
Cost 12,000 4,000 8,000
Mileage per gallon 40 8 12
Useful life 5 yrs 5yrs 5yrs
Salvage value 2,000 500 1,000

Required:
1. Which car should the company purchase?
2. How would your answer change if the price of gasoline increased to \$2 per gallon?

Solution Preview

Note: For the following answers the abbreviations have the following meanings

PVIF= Present Value Interest Factor
PVIFA= Present Value Interest Factor for an Annuity

They can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%
PVIF( n, r%)= =1/(1+r%)^n

1) Tom Thurlow wants to buy a boat but is short of cash. Two alternatives are available: Tom can accept \$2,000 per year from his brother for partial ownership in the boat, or he can earn money by renting the boat to others. Rental income would be \$2,500 per year.N Under either alternative, the boat will last eight years. If Tom rents the boat out, he will have to pay \$3,000 to overhaul the engine at the end of the fourth year.
Which alternative should Tom select, assuming that the cost of capital is 12% and that only quantitative considerations are involved?

Alternative 1: Accepting \$2,000 per year from brother

Since the cash flows are the same over 8 years we can use PVIFA factor to calculate NPV
PVIFA= Present Value Interest Factor for an Annuity
It can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%

Annual cash flow= \$2,000

n= 8
r= 12.00%
PVIFA (8 periods, 12.% rate ) = 4.96764

Annuity= \$2,000
Therefore, present value= 9,935 =2000x4.96764

Alternative 2: Accepting \$2,500 per year from rental

Since the cash flows are the same over 8 years we can use PVIFA factor to calculate NPV
PVIFA= Present Value Interest Factor for an Annuity
It can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%

Annual cash flow= \$2,500

We first calculate the Present value of \$2,500 to be received each year for 8 years
n= 8
r= 12.00%
PVIFA (8 periods, 12.% rate ) = 4.96764

Annuity= \$2,500
Therefore, present value= 12,419 =2500x4.96764

We then subtract the present value (PV) of the cost to be incurred at the end of 4 years

n= 4
r= 12.00%
PVIF (4 periods, 12.% rate ) = 0.635518

Future value= 3,000 to overhaul the engine
Therefore, present value= 1,906.55 =3000x0.635518

Therefore present value of alternative 2= 10,512.45 =12419-1906.55

Since the present value of alternative 2 = 10,512.45 is more than the present value of alternative ...

Solution Summary

Answers 2 questions on Capital Budgeting.
1) Choosing between the alternatives: accepting \$2,000 per year from his brother for partial ownership in the boat and renting the boat out
2) Net Present Value Used to Rank Alternatives: choose a new delivery car from among three alternatives

\$2.19

Cost of Capital, Capital Budgeting, Capital Structure, Forecasting, and Working Capital Management

Question 1: (Cost of Capital)

You are provided the following information on a company. The total market value is \$38 million. The company's capital structure, shown here, is considered to be optimal.
(see attached file for data)

a. What is the after-tax cost of debt? (assume the company's effective tax rate = 40%)
b. Assuming a \$4 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume floatation costs = \$0.00)
c. Assuming the risk-free rate is 1%, the expected return on the stock market is 7%, and the company's beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)?
d. What is the company's weighted average cost of capital (WACC)?

Question 2: (Capital Budgeting)

It's time to decide how to use the money your firm is expected to make this year. Two investment opportunities are available, with net cash flows as follows:
(See attached file for data)

a. Calculate each project's Net Present Value (NPV), assuming your firm's weighted average cost of capital (WACC) is 7%
b. Calculate each project's Internal rate of Return (IRR).
c. Plot NPV profiles for both projects on a graph).
d. Assuming that your firm's WACC is 7%:
(1) If the projects are independent which one(s) should be accepted?
(2) If the projects are mutually exclusive which one(s) should be accepted?

Question 3: (Capital Structure)

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
(See attached file for data)

The company's tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, Rs. The risk-free rate is 1 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (i.e., its "unlevered beta," bU, equals 1.0.)

On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Question 4: (Forecasting)

A firm has the following balance sheet:
(See attached file for data)

Sales for the year just ended were \$6,000, and fixed assets were used at 80 percent of capacity. Current assets and accounts payable vary directly with sales. Sales are expected to grow by 20 percent next year, the expected net profit margin is 5 percent, and the dividend payout ratio is 80 percent.

How much additional funds (AFN) will be needed next year, if any?

Question 5: Working Capital Management

The Chickman Corporation has an inventory conversion period of 60 days, a receivables collection period of 30 days, and a payables deferral period of 30 days. Its annual credit sales are \$6,000,000, and its annual cost of goods sold (COGS) is 60% of sales.

a. What is the length of the firm's cash conversion cycle?
b. What is the firm's investment in accounts receivable?
c. What is the company's inventory turnover ratio?
d. Identify three ways in which the company could reduce its cash conversion cycle?
e. What are the possible risks of reducing the cash conversion cycle per your recommendations in part d?

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