Question 1. Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for ten years. The company will have to provide support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.
a. What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis and discount the rates of 2% and 11%.
b. How many IRRs does this investment have?
c. What does the IRR indicate about this investment?
Question 2. You work for an outdoor play structure manufacturing company and are trying to decide between two projects:
Year -End Cash Flows ($ thousands)
Project 0 1 2 IRR
Playhouse -30 15 20 10.4%
Fort -80 39 52 8.6%
You can undertake only one project. If the cost of capital is 8%, use the incremental IRR rule to make the correct decision.
Question 3. Elm dale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in millions of dollars)
Year 1 Year 2
Revenues 125 160
Cost of goods sold and operating
Expenses other than depreciation 40 60
Depreciation 25 36
Increase in working capital 5 8
Capital Expenditures 30 40
Marginal corporate tax rate 35% 35%
a. What are the incremental earnings for this project for years 1 and 2?
b. What are the free cash flows for this project for the first two weeks?
Question 4: Markov Manufacturing recently spent $15 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 35%. The company plans to use straight-line depreciation.
a. What is the annual depreciation expense associated with this equipment?
b. What is the annual depreciation tax shield?
c. Rather than straight-line depreciation, suppose Markov will the MACRS depreciation methods for five year property. Calculate the depreciation tax shield for each year for this equipment under the accelerated depreciation schedule.
d. If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which should it choose? Why?
e. How might your answer to part (d) change if Markov anticipates that its marginal corporate tax rate will increase substantially over the next five years.