Fin 5219
Investment Decisions Homework
1.
NAU is faced with the decision of which word processor to choose. It can buy the Bang word
processor, which costs $8,000, and has an estimated annual, year-end maintenance cost of $2,000.
The Bang word processor will be replaced at the end of year 4 and have no value at the time
(maintenance cost for 4 years).
Alternatively, NAU could buy IOU word processor to accomplish the same identical work. The
IOU word processor would need to be replaced after three years. IOU costs only $4000, but
annual, year-end maintenance costs will be $2500 per machine (for three years).
NAU’s opportunity cost of funds is 14 percent. Because NAU is a nonprofit institution it does not
pay taxes. There is no salvage value for either machine. It is anticipated that whichever
manufacturer is chosen now will be the supplier of future machines. Would you recommend
purchasing the Bang or IOU?
Since revenue is the same we will compare the costs of the two machines:
Bang: PV = Investment + PV (maintenance costs) = 8,000 + 5,827 = 13,827
EAC = 4,745.64
IOU: PV = Investment + PV (maintenance costs) = 4,000 + 5,804 = 9,804
EAC = 4,222.89
Choose IOU machines.
Alternatively we can use equal horizons
BANG
Investment Costs = 8,000 + 8,000/1.14^4 + 8,000/1.14^8 = $15,541.11
Op Costs = $11,320.58
Total Costs = $26,861.69
IOU
Investment Costs = 4,000 + 4,000/1.14^3 + 4,000/1.14^6 + 4,000/1.14^9 = $9,752.26
Op Costs = $14,150.73
Total Costs = $23,902.99
Again choose IOU machines.
2. Compute the cash flows for the project whose details are given below:
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




The project is being set up on land owned by the firm. This land which is worth $2m now, and was
purchased a year ago for $1m.
The initial investment in plant and machinery will be $6m. Assume all assets have a life of 5 years.
Assume that the salvage value of its plant and machinery will be $1m.
The Net Working Capital will be $1m at the end of year 1 and $2m at the end of year 2. At the end of
the project life of 3 years, it hopes to recover its entire investment without loss in value.
Its EBDT are expected to be $5m in each of the next 3 years.
The firm plans to sell off its plant and machinery after 3 years for $2m and the land for $3m.
Corporate tax rate is 35%. Capital gains tax rate is 30%. The discount rate is 12%.
Yr 0
Yr 1
Yr 2
Yr 3
1.00
2.00
0.00
EBDT ($m)
5.00
5.00
5.00
Book Depreciation ($m)
1.00
1.00
1.00
EBT ($m)
4.00
4.00
4.00
Tax ($m)
1.33
1.08
1.35
Net Income ($m)
2.67
2.92
2.65
Tax Depreciation (%)
20.00
32.00
19.20
Tax Depreciation ($m)
1.20
1.92
1.15
EBT (for tax purpose)
3.80
3.08
3.85
Tax ($m)
1.33
1.08
1.35
Total Investment
8.00
Plant & M/C
6.00
Land
2.00
Net Working Capital
Profit-Loss Account
Corporate Tax Calculation
Capital Gains Tax Calculation
Proceeds from sale of asset - Plant and M/C
2.00
Proceeds from sale of asset - Land
3.00
Tax Book Value of Assets - Plant and M/C
6.00
4.80
2.88
1.73
Tax Book Value of Assets - Land
2.00
Profit on sale of assets
1.27
Capital Gains Tax
0.38
Summary of Cash Flows
Investment
(8.00)
Change in Net Working Capital
(1.00)
(1.00)
2.00
Net Income
2.67
2.92
2.65
Book Depreciation
1.00
1.00
1.00
Proceeds from sale of asset - Plant and M/C
2.00
Proceeds from sale of asset - Land
3.00
Capital Gains Tax
(0.38)
Net Cash Flow
(8.00)
2.67
2.92
10.27
Present Value
(8.00)
2.38
2.33
7.31
4.02
3.
You have been asked to evaluate a project with infinite life. Sales and costs are
projected to be $1000 and $500 respectively. There is no depreciation and the tax
rate is 30%. The real required rate of return is 10%. The inflation rate is 5% and
is expected to be 5% forever. Sales and costs will increase at the rate of inflation.
If the project costs $3000, what is the NPV?
Sales 1,000
Costs 500
Tax 30%
rr 10%
ri 5%
rn = (1.1*1.05)-1 = 15.5%
EBT = 1,000-500 = 500, After taxes 500 * (1-0.3) = 350 Perpetual cash flow stream
growing at 5%
350 / (0.155-.05) = 3,333.33 - 3,000
NPV = 333.33
4.
A project will produce operating cash flows of $45,000 a year for four years.
During the life of the project, inventory will be lowered by $30,000 and
accounts receivable will increase by $15,000. Accounts payable will decrease
by $10,000. The project requires the purchase of equipment at an initial cost of
$120,000. The equipment will be depreciated straight-line to a zero book value
over the life of the project. The equipment will be salvaged at the end of the
project creating a $15,000 after-tax cash flow. At the end of the project, net
working capital will return to its normal level. What is the net present value of
this project given a required return of 14%?
Year
Op Cash
Change in
WorkCap
0
1
45,000
2
45,000
3
45,000
4
45,000
5,000
-5,000
Equip
-120,000
15,000
Sum
-115,000
PV
-115,000 39,473.68 34,626.04 30,373.72 32,564.42
NPV
22,037.86
45,000
45,000
45,000
55,000
5.
Marshall’s & Co. purchased a corner lot in Eglon City five years ago at a cost of
$640,000. The lot was recently appraised at $810,000. At the time of the
purchase, the company spent $50,000 to grade the lot and another $4,000 to
build a small building on the lot to house a parking lot attendant who has
overseen the use of the lot for daily commuter parking. The company now
wants to build a new retail store on the site. The building cost is estimated at
$1.5million. What amount should be used as the initial cash flow for this
building project?
The projected cost of the building plus the opportunity cost of the land
1,500,000 + 810,000 = $2,310,000
6. You own a house that you rent for $1,200 a month. The maintenance expenses on
the house average $200 a month. The house cost $89,000 when you purchased it
several years ago. A recent appraisal on the house valued it at $250,000. The
annual property taxes are $5,000. If you sell the house you will incur $20,000 in
expenses. You are deciding whether to sell the house or convert it for your own
use as a professional office. What value should you place on this house when
analyzing the option of using it as a professional office? The discount rate is 12%.
Opportunity costs of selling the house minus the costs associated with the sale
250,000 – 20,000 = $230,000
7. The projects have the following NPVs and project lives.
Project
NPV
Life
Project A $5,000 5 years
Project B $7,000 7 years
If the cost of capital is 10%, which project would you accept?
N
I/Y
PV
PMT
FV
Project A
5
10%
$5,000
?
0
Project B
7
10%
$7,000
?
0
EAR
$1,318.99
$1,437.84
Choose Project B
8.
OM Construction Company must choose between two types of cranes. Crane A
costs $500,000, will last for 5 years, and will require $60,000 in maintenance each
year. Crane B costs $750,000 and will last for six years and will require $30,000
in maintenance each year. Maintenance costs for cranes A and B are incurred at
the end of each year. The appropriate discount rate is 12% per year. Which
machine should OM Construction purchase?
Crane A
500,000
Crane B
750,000
5
12%
?
60,000
0
6
12%
?
30,000
0
PV
$216,286.57
$123,342.22
Total PV
$716,286.57
$873,342.22
N
I/Y
PV
PMT
FV
Crane A
5
12%
716,286.57
?
0
Crane B
6
12%
873,342.22
?
0
PMT/ EAC
$198,704.87
$212,419.29
Purchase
Op costs
N
I/Y
PV
PMT
FV
EAC
Purchase Crane A
9.
Kurt’s Kabinets is looking at a project that will require $80,000 in fixed assets
and another $20,000 in net working capital. The project is expected to produce
sales of $110,000 with associated costs of $50,000. The project has a 4-year life.
The company uses straight-line depreciation to a zero book value over the life of
the project. The tax rate is 30%. What is the operating cash flow for this project?
Depreciation per year = 80,000/4 = 20,000
(Sales – Costs – Depreciation) * (1-tax) + Dep = OCF
(110,000 – 50,000 - 20,000) * (1-0.30) + 20,000 = $48,000
10.
A project requires an initial investment of $180,000 and is expected to produce a
cash flow before taxes of 120,000 per year for two years. [i.e. cash flows will
occur at t = 1 and t = 2]. The corporate tax rate is 30%. The assets will be
depreciated using MACRS – 3 year schedule: t=1, 33.33%; t = 2: 44.45%; t = 3:
14.81%; t = 4: 7.4%. The company's tax situation is such that it can make use of
all applicable tax shields. The opportunity cost of capital is 10%. Assume that
the asset can be sold for book value. Calculate the NPV of the project at the end
of two years
0
Initial Cost
Cash Flows
Dep
Taxable
Income
Taxes (30%)
Net Income
Dep
Take Home
PV
1
2
-180,000
-180,000
120,000
59,994
60,006
120,000
80,010
39,990
18,002
42,004
59,994
11,997
27,993
80,010
101,998
92,726
Salvage = 180,000 * (1 - 0.3333 – 0.4445) =39,996
PV of Salvage = 33,055
NPV = -180,000 + 92,726 + 89,259 + 33,055 = 35,040
108,003
89,259