Problem 1. Certainty equivalents – Accept – reject decision
Pleasantville ball valve has constructed a table, shown below, that gives expected cash inflows and certainty equivalent factors for these cash inflows. These measures are for a new machine with a five-year life that requires an initial investment of $95,000. The firm has a 15 percent cost of capital, and the risk-free rate is 10 percent.
|
Year (t)
|
Cash Inflows (CFt)
|
Certainty equivalent factors (at)
|
|
1
|
$35,000
|
1.0
|
|
2
|
$35,000
|
.8
|
|
3
|
$35,000
|
.6
|
|
4
|
$35,000
|
.6
|
|
5
|
$35,000
|
.2
|
a. What is the net present value (unadjusted for risk)?
b. What is the certainty equivalent net present value?
c. Should the firm accept the project? Explain why.
d. Management has some doubts about the estimate of the certainty equivalent factor for year 5. There is some evidence that it may not be any lower than that for year 4. What impact might this have on the decision you recommended in C? Explain.
Problem 2. Lease versus purchase
Northwest lumber company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 40% tax bracket, and its after-tax cost of debt is 9%. The term of the lease and purchase plans are as follows:
Lease: The leasing arrangement requires end-of-year payments of $19,800 over 5 years. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $24,000 at termination of the lease.
Purchase: If the firm purchases the machine, its cost of $80,000 will be financed with a 5-year, 14% loan requiring equal end-of-year payments of $23,302. The machine will be depreciated under MACRS using a 5-year recovery period. The firm will pay $2,000 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5-year recovery period.
a. Determine the after-tax cash outflows of Northwest Lumber under each alternative.
b. Find the present value of the after-tax cash outflows using the after-tax cost of debt.
c. Which alternative, lease or purchase, would you recommend? Why?