# Geico Problem: Capital Budgeting Decisions

Geico

Geico is considering expanding an existing plant on a piece of land it already owns. The land was purchased 15 years ago for $325,000, and its current market appraisal is $820,000. A capital budgeting analysis shows that the plant expansion has a net present value of $130,000. The expansion will cost $1.73 million, and the discounted cash inflows are $1.86 million. The expansion cost of $1.73 million does not include any provision for the cost of the land. The manager preparing the analysis argues that the historical cost of the land is a sunk cost, and since the firm intends to keep the land whether or not the expansion project is accepted, the current appraisal value is irrelevant.

Should the land be included in the analysis? If so, how?

Housing Markets

A home identical to yours in your neighborhood, sold last week for $150,000. Your home has a $120,000 assumable, 8% mortgage (compounded annually) with 30 years remaining. An assumable mortgage is one that the new buyer can assume at the old terms, continuing to make payments at the original interest rate. The house that recently sold did not have an assumable mortgage; that is, the buyers had to finance the house at the current market rate of interest, which is 15%. What price should you ask for your home?

A third home, again identical to the one that sold for $150,000, is also being offered for sale. The only difference between this third home and the $150,000 home is the property taxes. The $150,000 home's property taxes are $3,000 per year, while the third home's property taxes are $2,000 per year. The differences in the property taxes are due to vagaries in how the property tax assessors assessed the taxes when the homes were built. In this tax jurisdiction, once annual taxes are set, they are fixed for the life of the home. Assuming the market rate of interest is still 15%, what should be the price of this third home?

Mortgage Department

Suppose you are the manager of a mortgage department at a savings bank. Under the state usury law, the maximum interest rate allowed for mortgages is 10% compounded annually.

a. If you granted a $50,000 mortgage at the maximum rate for 30 years, what would be the equal annual payments?

b. If the current market internal rate on similar mortgages is 12%, how much money does the bank lose by issuing the mortgage described in (a)?

c. The usury law does not prohibit banks from charging points. One point means that the borrower pays 1% of the $50,000 loan back to the lending institution at the inception of the loan. That is, if one point is charged, the repayments are computed as in (a), but the borrower receives only $49,500. How many points must the bank charge to earn 12% on the 10% loan?

Watson's Bay

Watson's Bay Co. is considering a contract to manufacture didgeridoos. Producing didgeridoos will require an investment in equipment of $100,000 and operating costs of $15 per didgeridoo produced. The contract calls for the company to deliver 2,000 didgeridoos a year for each of 4 years at a price of $30 per didgeridoo. At the end of 4 years the equipment is expected to be sold for $10,000. The equipment will be depreciated as follows:

Year Depreciation Factor

1 0.3333

2 0.4445

3 0.1481

4 0.0741

The depreciation factor is applied to the full cost of the equipment (i.e., salvage value is not considered when depreciation is determined). The tax rate is 33%, and the market rate of return for investments of this risk is 20%. Should Watson's Bay Co. take the contract to manufacture didgeridoos?

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Geico

Geico is considering expanding an existing plant on a piece of land it already owns. The land was purchased 15 years ago for $325,000, and its current market appraisal is $820,000. A capital budgeting analysis shows that the plant expansion has a net present value of $130,000. The expansion will cost $1.73 million, and the discounted cash inflows are $1.86 million. The expansion cost of $1.73 million does not include any provision for the cost of the land. The manager preparing the analysis argues that the historical cost of the land is a sunk cost, and since the firm intends to keep the land whether or not the expansion project is accepted, the current appraisal value is irrelevant.

Should the land be included in the analysis? If so, how?

Housing Markets

A home identical to yours in your neighborhood, ...

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