Commerce 2FA3
Tutorial 9
March 2001
Question 1:
Barney’s Industries Inc. is considering two proposals for the use of
factory space freed up by a discontinued product line. Project A
would cost $40,000 (class 8, 20%) to start and is expected to
generate positive cash flows of $20,000 per year (before tax) for 5
years, with no salvage value. Project B costs $60,000 to start (class
8) but would generate $30,000 per year for 4 years with a salvage
value of $7,500. Both projects are likely to be repeated. Which of
these projects is better if Barney’s has a cost of capital of 12.5% and
a marginal tax rate of 35%?
r
d
Tc
Cost
PVTS
n
PVIFA
Annual CF
After tax
PV CF
Salvage
PV Salvage
PVTS lost
NPV
EAA
Project A
12.5%
20.0%
35.0%
40,000.00
8,136.75
5
3.5606
20,000.00
13,000.00
46,287.39
14,424.14
4,051.08
Project B
12.5%
20.0%
35.0%
60,000.00
12,205.13
4
3.0056
30,000.00
19,500.00
58,609.97
7,500.00
4,682.21
1,008.48
14,488.83
4,820.55
Cost of capital
CCA Rate
Marginal Tax
Initial Cost
Tax Shield
Years
For CF and EAA
CF times (1-Tc)
Don't forget this.
A slight edge to B
Definitely B
Both standard NPV and EAA recommend project B, though the
recommendation is much stronger with EAA.
Commerce 2FA3
Tutorial 9
March 2001
Question 2:
BIG Inc. is considering a capital investment project (all figures after
tax) that would cost $100 million. Expected cash flows would be $20
million per year for 10 years. This projection is based on a 40%
chance of $25 million, a 20% chance of $20 million and a 40%
chance of $15 million. The CF in the first year will be the CF for the
entire project. BIG’s cost of capital is 10%. Analyze the project
using NPV, IRR, MIRR, PI, and Payback.
BIG can increase the initial investment to $110 million to create
managerial options. If they get the $25 result they could increase this
cash flow to $40 for an additional $70 million. They could also or shut
the project down and recover $90 million dollars. Is this additional
investment worthwhile?
Payback = 100/20 = 5 years. No decision, cutoff not given.
NPV = -100 + 20 x PVIFA = $22.89 million. Accept Project
(1 + MIRR) 10 = 20 x FVIFA/100  MIRR = 12.3% > 10% Accept
0 = -100 + 20 x PVIFA(IRR, 10)  guess 15%  NPV = 0.375
NPV > 0, increase discount rate  guess 15.1%  NPV = -0.006
NPV < 0, decrease discount rate. IRR = 15.0984%.
Both options increase the value of the remaining cash flows.
NPV high = -110 -45/1.10 + 40 x PVIFA(10%, 9)/1.10 = 58.51
NPV medium = -110 + 20 x PVIFA(10%, 9) = 12.89
NPV low = -110 + 105/1.10 = -4.55
NPV project = 40%x58.51 + 20%x12.89 + 40%x-4.55 = 26.14
The value of the options is greater than the cost of those options
since the NPV is greater if we include the options and the
additional cost.
Commerce 2FA3
Tutorial 9
March 2001
Question 3:
A firm has the following projects under consideration.
Project
A
B
C
D
E
Cost
1,000,000
2,000,000
1,500,000
3,000,000
500,000
NPV
100,000
175,000
175,000
200,000
35,000
If the firm has a cost of capital of 15% and a hard cap on capital
expenditures of $5 million, which projects should they accept if all of
the projects could be delayed? What would the appropriate decision
be if project D must be done now or never?
Project
C
A
B
E
D
numbers in thousands
Cost
NPV
1,500
175
1,000
100
2,000
175
500
35
3,000
200
PI
1.117
1.100
1.088
1.070
1.067
C. Cost
1,500
2,500
4,500
5,000
8,000
If all of the projects can be repeated we add projects until the
cumulative cost reaches $5 million.
In this case all projects
except project D will be accepted this year. The NPV of this is
$485,000.
Project D would be done next year for a NPV of
200/1.15 or $174 thousand for a total of $659k.
If project D must be done now or never, the company should do
project D now and also projects C and E. The NPV this year would
be $410k and $275 next year (PV $239k). This would have a PV
of $649k vs. $485k if project D were never done.
Commerce 2FA3
Tutorial 9
March 2001
Question 4:
SloGro Inc. has earnings per share of $2.25. They have profitable
growth opportunities with a value of $1.95 per share. If this
information is publicly available and the market is semi-strong form
efficient, what is the price per share of SloGro if investors require a
9% rate of return? What would the impact be if SloGro had a new
project that added $0.75 to the NPVGO if that information was not
available to the public? What should happen if they announce the
project?
P 1 NPVGO
 
E r
E
P
1
1.95


 11.98
2.25 0.09 2.25
P  12  2.25  $26.95
The initial P/E ratio of the firm should be just under 12 giving a
price of $26.95.
The existence of the new project would not add any value to the
company until that information became available to the public. If
the market were strong form efficient, the price would increase.
If they announce the project, the price of the company should
increase to P = (1/0.09 + 2.70/2.25) x 2.25 = $27.70.
The $0.75 increase should be no surprise since the equation can
be written as P = E/r + NPVGO.