Corporate Investments and Capital Budgeting Problems
1. Suppose you have to choose between two mutually exclusive investment projects with the following cash flows (all numbers in $1,000s):
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t = 0
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t = 1
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t = 2
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Project A
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-$400
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$250
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$300
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Project B
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-$200
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$140
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$179
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Both projects have a discount rate of 9%. Determine the NPV and the IRR for each of the projects, and describe how you would make the correct project selection decision based on both decision criteria.
2. Low-energy light bulbs typically cost $3.60, have a life of 9 years, and use about $2.00 in electricity a year. Conventional light bulbs are cheaper to buy, for they cost only $0.60, but they last only a year and use about $7.00 in electricity. If the discount rate is 4%, which product is cheaper to use? (Hint: first determine the NPV of the costs associated with each type of light bulb, and then convert this NPV into an equivalent annuity, or an equivalent annual cost).
3. A company buys a machine for $500,000 and depreciates it on a straight-line basis over a five-year period. The investment would result in pre-tax cash cost savings of $200,000 per year, for five years. At the end of 5 years, it is estimated that the machine can be sold for $75,000. The gain on the sale of the machine would be taxed at a 40% tax rate. Determine the correct cash flows associated with the purchase of the machine. Is the investment in the machine attractive in economic terms? Motivate your answer and show your calculations. You can assume that the appropriate discount rate equals 8%.
4. Vandelay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,100,000 and will last for six years. Variable costs are 35% of sales, and fixed costs are $150,000 per year. Machine B costs $4,500,000 and will last for nine years. Variable costs for this machine are 30% of sales and fixed costs are $100,000 per year. The sales for each machine will be $9,000,000 per year. The appropriate discount rate is 10% and the tax rate is 35%. Both machines will be depreciated on a straight line basis. If the company plans to replace the machine when it wears out on a perpetual basis, which machine should you choose? Explain your answer and show all your calculations.
5. An auto plant that costs $100 million to build can produce a new line of cars that will generate cash flows with a present value of $140 million if the line is successful, but only $50 million if it is unsuccessful. You believe that the probability of success is only about 50%. Answer the following three questions based on this information.
(i) Would you build the plant?
(ii) Suppose that the plant can be sold for $90 million to another automaker if the line is not successful. Would you build the plant under these conditions?
(iii) Illustrate the option to abandon using a decision tree.
6. A manager at a consumer electronics firm is considering a 5-year project to improve its packaging process for cables and other accessories and reduce waste. The project requires a temporary product line to be set up in a warehouse that is currently rented out to a local distributor. The manager has collected the following information on the project:
- The project requires an immediate investment of $500,000 in new equipment. The equipment will have a 10-year economic life and will be depreciated straight-line to a salvage value of zero. After 5 years, the equipment can be sold for $300,000.
- The production line is expected to produce revenues of $500,000 per year (starting in year 1) and its operating cash costs are expected to be $200,000 per year.
- The rent the firm receives on its warehouse equals $100,000 per year. The warehouse has been fully depreciated and the plans to sell the warehouse at the end of year 5 for $300,000, irrespective of whether the project will be undertaken.
- Operating the product line will require an immediate investment of $150,000 in Net Working Capital. The level of NWC will remain constant for the duration of the project.
- Since the project reduces waste, the firm can claim an immediate one-time tax credit of $20,000 if it sets up the product line.
The manager has estimated that the relevant cost of capital for an investment of this type equals 15%. The marginal corporate tax rate for the electronics firm is 40%. Furthermore, you can assume that all cash flows are realized at the end of the year. Should the manager go ahead with the investment project? Motivate your approach and show your calculations.