1. Consider the following two mutually exclusive projects
Year 0 1 2 3 4
Cash Flow A -$350,000 25,000 70,000 70,000 430,000
Cash Flow B -$35,000 17,000 17,000 17,000 11,000
Whichever project you choose, if any, the required return is 15% per year
(a) If you apply the payback method, which investment will you choose and why?
(b) If you apply the NPV method, which investment will you choose and why?
(c) If you apply the IRR method, which investment will you choose and why?
(d) If you apply the Pro tability Index method, which investment will you choose and why?
(e) Based on (a)-(d), which investment will you choose and why?
2. A project has the following cash flows:
Year 0 1 2
Cash Flow $64,000 -30,000 -48,000
(a) What is the IRR of the project?
(b) If the required return is 12% should the project be accepted?
(c) What is the NPV of the project? Should it be accepted based on NPV method?
3. Deer Co. needs an outside contractor to supply it with 260,000 boxes of special screws to support its production facilities. Your company has decided to submit a bid for this contract. It will cost you $940,000 to install the equipment needed to start production. You will need to depreciate this cost to zero using straight line method over the life of the project. You estimate that in 5 years the salvage value of the equipment will be $80,000. Your xed cost of production is $320,000 per year and your variable cost is $7.50 per box. You also need an initial investment in working capital of $95,000, which will be recovered once the project is over. Your tax rate is 35% and your required cost of capital is 13%. What is the bid that you should submit?
4. Chelo Co. is considering a 6-year project to improve its production e ciency. A new equipment will cost $600,000 and will result in $210,000 in annual pre-tax cost savings. The equipment will be depreciated to zero using straight line method and it is likely to have a salvage value of $90,000. The equipment requires an initial increase of $20,000 in inventory for spare parts and additional increase of $4,000 per year over the next 6 years. Inventory will be reduced to zero one year after the project is completed. The tax rate for the rm is 35% and the cost of capital is 10% per year. Should Chelo purchase and install the new equipment?
5. Initech Mining Co (IMC) is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia and Kentucky. The company operates deep mines as well as strip mines. Most of the coal is mined under contract, with excess production sold on the spot market.
The coal mining industry, especially high-sulfur coal operations such as IMC, has been hard hit by environment regulations and low natural gas prices. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfer coals. IMC has been approached by MEC with a request to supply coal for its electric generators for the next four years. IMC does not have enough capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years ago for $6 million. Based on a recent appraisal, the company feels it could receive $9 million on a pre-tax basis if it sold the land today.
Strip mining is a process where layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would simply remove the coal and leave the land in an unusable condition. Changes in the mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to near its original condition. The land can then be used for other purposes. As they are operating at full capacity, IMC will need to purchase additional equipment, which will cost $28 million. The equipment will be depreciated over 7 years using straight line method. The contract is for four years. At that time, the coal from the site will be entirely removed. The company feels that the equipment can be sold for its book value.
The contract calls for the delivery of 600,000 tons of coal per year at a price of $34 per ton. IMC feels the coal production will be 650,000 tons, 725,000 tons, 810,000 tons and 740,000 tons, respectively over the next four years. The excess production will be sold in the spot market at an average of $40 per ton. Variable costs amount to $13 per ton and xed costs are $2,500,000 per year. The mine will require a net working capital investment of 5% of sales. The net working capital will be built one year prior to the sales.
IMC will be responsible for reclaiming the land at termination of the mining. This will occur in year 5. The company uses an outside company for reclamation of all the company's strip mines. It is estimated the cost of reclamation will be $4 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park. This will occur in year 6 and will result in a charitable expense deduction of $6 million.
IMC's balance sheet shows that its Debt-Total Asset ratio is 0.4. It has used 20% cost of equity in the past and the rate of interest that it pays to its creditors is 8% per year. IMC's faces a 38% tax rate.
You have been approached by the CFO, Mr. Lumbergh, to analyze the project. Calculate the NPV of the project. Should IMC accept the project?