Assignment:
Financial Model Evaluation—Assume in the 1999 timekame OSCar had planned to establish their consulting service by investing S50 million in the business. A financial consultant provided the following estimates of cash flows for the next 15 years:
Net cash flow ($000):
|
Year
|
0
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
9
|
10
|
11
|
12
|
13
|
14
|
15
|
|
After
|
-50,000
|
5,000
|
5,000
|
5,000
|
5,000
|
5,000
|
8,000
|
8,000
|
8,000
|
8.000
|
11,000
|
11,000
|
11,000
|
11.000
|
11.000
|
56,000
|
|
Tax
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash flow
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Web site and product development and promotion costs are included in the above figures. The estimates represent expected after-tax cash flows. After year 15, it is anticipated that OSCar would be acquired by one of the automobile manufacatrers for about $55 million
Problem 1:
Scenario 1: The consultant is fairly oonfident of the after tax cash flow estimates and you accept them as reasonable expectations.
a. If the firm' s cost of capital is 20% and you use this cost of capital o discount the cash flow% what is the net present value (NPV) of this proposal? Based solely on the calculated NPV, do you recommend prcceeding with the project?
b. In WIZ ctart words, define the term "cost of capital." Why is one firm's cost of capital different from that of another firm? Why do we use the cost of capital to evaluate investment alternatives? .
c. What is the payback period for this initiative? Would you accept or reject this project based on the paYoack period. Why or why not? What other considerations (or information) would affect your decision?
d. In your own words, define "internal rate of return." What is the internal rate of return for the above cash flows?
e. Assume the firm's cost of capital is not 20%; hence, the CEO wars you to determine it. You consult an expert who tells you the firm's beta is 125: the average risk- free rate on treasury bonds is ,t% and the expected retain on the market is 12%. If the firm is financed by 100% equity, what is its cost of capital?
f. If the firm is funded by 70% debt with an interest rate of 6.5% and the rest by equity, what is the cost of capital in this case? Assume the firm's tax rate is 33%.
Problem 2.
Scenario 2: The consultant informs you that the estimate of ash flows is highly uncertain/volatile .:versus being a pretty solid estimate): the product can bomb or it can be a screaming success (cash flows much lower or much greater than computed expected values). in fact the con sutant thinks that OSCar may have to inject in some more investment capital in year S and 10 to realize the streams of income he has preOeted How does this alter your approach for considering the proposed investment?