Financial Management
| NOTE: Any final answer that is a rate of return (whether it be required, internal, expected, etc.) must be rounded | |
| to 100th of a percentage if reported as a percentage (e.g., 84.21%) or to 4 places if reported as a decimal. Any fina | |
| answer that is a dollar amount greater than $1 million must be reported to the nearest dollar; otherwise, please re- | |
| port to the nearest penny. A penalty will be applied to each instant wherein this requirement is violated | . |
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NOTE: Before submitting your work, please see page 1 of the syllabus for mandatory file-naming conventions.
- 1. (14) Dave Alvin, the CFO of Blasters Powertrain Products (BPP) has requested your assistance in evaluating a capital budgeting proposal. The proposal involves the production of a new line of gearboxes for use in heavy freight applications. Research and development costs to develop this new line of gearboxes were $570,000 last year (2017). Production of the new product would require investment in (i.e., the purchase of) new machinery at a cost of $6.6 million, with a useful life of 4 years. BPP has conferred with its tax accountant and has been informed that they must depreciate the machinery under the MACRs 5-year class. (See page 4 for a MACRS depreciation schedule.) Forecasts indicate that the machinery can be sold for a market value of $540,480 at the end of the 4-year period.
Management expects sales to be $7.65 million in year 1, and sales are projected to increase by 2%/year over the life of the project. Variable production costs are projected to be $5.85 million in year 1 and management expects these costs to increase by 1%/year over the life of the project. Fixed production costs are expected to be $165,000 each year.
If BPP produces the new line of gearboxes, BPP will need to make additional investments in Net Working Capital (NWC) to support the increased operations. In particular, NWC (entering any year) is expected to be 10% of the projected sales for that year. That is, the NWC balance at t=0 would be 10% of the projected sales for year 1, the NWC balance at t=1 would be 10% of the projected sales for t=2, and so on. The cumulative investments in NWC made as a result of this project would be recovered in the project’s final year. In other words, the NWC balance will drop to $0 at t = 4.
The discount rate (also called cost of capital) used to evaluate this project would be 10.75% (although this variable is not needed in this problem, given the instructions below), and the relevant tax rate is 25.00%.
Develop the incremental cash flow projections for this proposal. Your worksheet should resemble the numerous examples covered in Lesson 6, including the terms relating to “operating” cash flows, ΔNWC, and net capital spending. Of course, any given column in your worksheet should contain the total cash flow for that column. [Note: Normally, you would then use these cash flows to calculate NPV and IRR of the decision to either (1) buy the new press and sell the old one or (2) keep the old press. If NPV > 0 (and, equivalently, IRR > required return), then the firm will choose option 1. If NPV < 0 (and, equivalently, IRR < required return), then the firm will choose option 2. However, this assignment already contains an adequate number of other NPV and IRR calculations.]
- (14) A factory is considering replacing its existing coining press with a newer, more efficient one. The existing press was purchased 4 years ago for $400,000 and is being depreciated according to a 7-year MACRS depreciation schedule. (See page 4 for the MACRS schedules.) The factory’s CFO estimates that the existing press has 5 years of useful life remaining. The new press’s purchase price is $560,000. Installation of the new press would cost an additional $40,000; this installation cost would be added to the depreciable base (i.e., it would be capitalized) and then depreciated across time. The new press (if purchased) would be depreciated using the 7-year MACRS schedule although the factory will retire or sell the new press after 5 years. Interest expenses associated with the purchase of the new press are estimated to be roughly $8000 per year for the next 5 years.
(2, continued)If the new press is purchased, revenues will remain the same as they’d be if the old press is maintained.
However, the appeal of the new press is that it will reduce production costs by $162,000/year for the next 5 years. Also, if the new press is purchased, the old press can be sold for $60,000 today. The CFO believes that the new press would be sold for $90000 in 5 years; the old press’s value at t=5 will be $0. NWC would not be affected. The company’s marginal tax rate = 34.0%. The cost of capital (i.e., the required rate of return) for this project is 7.5% (although this variable is not needed in this problem, given the instructions below)
Calculate the incremental cash flows for this replacement decision, for time 0, for each year of operation, and at termination. Please make sure that you show clear work as to determine how you arrived at your incremental cash flows! [Hint: The old press’s net book val. at t=0 is $124,960. Hint: I want to remove any doubts surrounding the depreciation schedule for the old machine. Yes, if kept in place, the existing machine will reach a book value of $0 before the machine is retired. Many long-term assets are still functional after they’re fully depreciated.] [Note: Normally, you would then use these cash flows to calculate NPV and IRR of the incremental decision to either (1) buy the new press and sell the old one or (2) keep the old press. Next, you would make a conclusion about whether or not the existing coining press should be replaced at this time. However, this assignment already contains an adequate number of other NPV and IRR calculations.]
- (5) Your firm is considering a tree farm with a required return of 12%. If you start the tree farm today, your firm will incur an initial cost of $490 and will receive cash inflows of $365/year for 3 years. If you instead wait one year to start the farm, the initial cost will rise to $520 and the cash flows will increase to $420 a year for the following 3 years. If you wait for two years to start, the initial outlay will be $560 and the cash flows will be $450/yr. at t = 3, 4, and 5. The property is essentially forecasted to be worthless after 3 years of trees have been grown and harvested. Your firm has three options: start the tree farm now, start it one year from now, or start it two years from now. Calculate a fair price (a fair valuation) for this project and briefly explain how you arrive at the price.
- A firm is considering a project with a 6-year life and an initial cost of $33,750. The appropri-ate discount rate for this project is 13%. The firm expects sales to be $11,500/year for the first 3 years. Beyond year 3, there is a 40% chance that sales will fall to $6,000/year for years 4, 5, and 6 and a 60% chance that sales will rise to $12,500/year for those three years. The project also contains an abandonment option: the firm will have the option to abandon the project after 3 years (i.e., at t=3) by selling it for $20,000 (after taxes). By the time the firm faces the decision whether to continue or abandon at t=3, it will know which state will be realized in years 4
through 6 (should the project be continued).
- Calculate the expected net present value of this project in the absence of the abandonment option. (4)
- Calculate the value (in today’s dollar terms) of the abandonment option. (4)
- 5. Bubba Golf is considering manufacturing a new ‘super-sized’ golf club to compete with the highly successful debut of the Holywood Smasher, produced by McIlroy Industries. The initial investment for this project would include $3.0 million in new machinery and an additional $240, 000 in setup costs. (The amount to be capitalized and then depreciated is the sum of the machinery and setup costs.) The project life would be 4 years; however, in accordance with the IRS, the depreciation method would be 5-year MACRS. (See page 4 for a MACRS schedule.) The rele- (#5, continued) vant required return is 14% and the applicable tax rate is 34%. For simplicity, assume that a $600,000 investment in NWC is required immediately (to be recovered at the project’s end) and the assets involved would have a salvage value of $108,000 (before any tax-expense implications) at the end of 4 years. At the end of this problem statement, you’ll find year1 projections* that reflect the best estimates from the marketing and engineering teams.
- (5) Conduct a scenario analysis to calculate net present value (NPV) for each of the three scenarios specified. Please create (and submit) only one worksheet that can be generalized across all cases, as opposed to creating three different worksheets for all scenarios. Make a note of all three NPVs to be used in part b. Then, leave your single worksheet with the Most Likely Scenario values as the inputs.
- (3) What is the expected (i.e. probability-weighted) NPV? For part b, please create a separate worksheet that tabulates all three scenario-specific NPVs and also shows the overarching expected NPV calculation. This worksheet should not contain your entire cash flow worksheet; it should be very succinct.
- (3) Now, return to your master spreadsheet and conduct a sensitivity analysis on sales (# units), price per unit, variable costs, and fixed production costs. Specifically, calculate the dollar change in NPV, given a 10% increase in the input variable from its base-case (most-likely) value. For example, hold all input variables constant, increase sales to 44,000 units, calculate the new NPV, and report the change in NPV for a 10% increase in sales. Next, again hold all input variables constant, increase price per unit to $363.00, calculate the new NPV, and report the change in NPV for a 10% increase in selling price per unit. Do the same for the other two input variables and create a brief table that summarizes the work. This analysis will show NPV’s sensitivity to changes in the various input variables. Finally, in order from most to least critical, indicate which inputsshould perhaps be revisited to ensure that it’s been forecasted accurately.
| Pessimistic | Most Likely | Optimistic | |
| Sales (in units) | 35,000 | 40,000 | 45,000 |
| Price per unit | $290 | $330 | $370 |
| Variable costs (per unit) | $206 | $198 | $190 |
| Fixed Production costs | $2,100,000 | $1,800,000 | $1,500,000 |
| Probability of outcome | 30% | 50% | 20% |
*For simplicity, assume that the state which is realized at t=1 will be in effect for the project’s duration.
- 6. A new project that is being considered requires an initial investment of $375,000. The expected future cash flows are $250,000 per year for four years. Assume the appropriate discount rate is 15%.
- What is the NPV? (2)
- Suppose that the firm that’s considering this project has a market value of $2.2 million. If the firm accepts this project, what will be the firm’s new market value? (2) c. What is the IRR? (2 pts.)
- d. What is the discounted payback period? (2) Include partial periods (e.g., x.xx years) in your response.
- 7. A firm is considering a mining project with the following cash flows (with the final cash flow being negative, perhaps due to an extensive land reclamation in the project’s final year):
C0 = –$280, C1 = $280, C2 = $308, C3 = $364, C4 = $280, and C5 = –$1036.
(a) From among the following multiple-choice answers, calculate this project’s internal rate(s) of return: 5.070%, 25.225%, 33.333%, 51.909%, 82.425%. (2 pts.) (b) If the required return is 30.000%, should the project be rejected or accepted? Briefly, clearly justify and explain your
reasoning. (2 pts.)
MACRS Depreciation Percentages — Half-Year Convention
RECOVERY PROPERTY CLASS
YEAR 3-YEAR 5-YEAR 7-YEAR
- 33% 20.00% 14.29%
- 45 32.00 24.49
- 81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93
- 76 8.92
- 93
- 46
Totals 100.00% 100.00% 100.00%
