Problem 1:
ExSalvo, a limited partnership (whose partners are individuals in the 39.6% income tax bracket) is considering salvaging a Spanish treasure ship sunken in the Caribbean Sea. The partnership previously spent $10,000 in 1998 locating the ship and planning its recovery.
The deal requires ExSalvo to spend $50,000 now (on 1/1/99) for salvage equipment that would be immediately placed in service. The equipment is 7 year recovery property; MACRS tables list the Recovery percentages applicable in years 1 through 8 as, respectively, 14.29%, 24.49%, 17.49%, 12.49%, 8.93%, 8.92%, 8.93%, and 4.46%. The partnership must also invest %20,000 on 1/1/00 (the end of year one or beginning of year two) in working capital (to cover the receivables on the salvage).
The forecast values of sales of salvaged treasure are also $80,000 for year one (1999) and $95,000 for year two (2000). A fee will have to be paid to the island nation closest to the sunken ship equal to 30% of the gross treasure sales each year. Other operating expense to be incurred are $20,000 for year one (1999) and $25,000 for year two (2000).
At the end of year two (12/31/00) all actual salvage activities will be terminated; all further treasure sales, island fees, operating costs, and depreciation deductions (because the equipment is no longer in services) are zero after the year 2000.
The partnership expects to spend the year 2001 (year 3) arranging to sell the salvage equipment. So on 12/31/01 ExSalvo actually receives (nets) $24,000 from a used equipment broker and liquidates its working capital investment (finally collects all of its receivables).
ExSalvo uses a 12% discount rate for similar risk projects. Use net Present Value analysis to decide whether or not ExSalvo should buy into this deal. Show your work!
If it had calculated the Internal Rate of Return (IRR) for the ExSalvo treasure deal above, would it have been less or more or less the 12% discount rate? How can you tell? Do not actually calculate the IRR.
Problem 2. Amber Inc. hires you as an analyst to calculate its weighted Average cost of capital. Amber has $5 million face value of bonds outstanding that currently trade at 92% of face value and yielding 7.25%. Amber has 100,000 shares of preferred stock outstanding that are worth $10.50/share in the market now and pay a fixed annual dividend of $1/share. Amber's common stock is currently valued at $27/share and there are 150,000 shares issued and outstanding. The common stock currently pays a dividend of $0.20/quarter and dividends are expected to grow 12.25% compound over the foreseeable future. Amber's marginal income tax rate is 35%. Please show your calculations for amber's Weighted Average Cost of Capital.
How should Amber use this Weighted Average Cost of Capital number to evaluate a potential investment projects in a new venture that has a beta of .88? Assume Amber's existing business has a beta equal to one.