Topic: Capital Budgeting

1.

Marsh Motors has to choose one of two new machines. Machine 1 costs $180,000, has a 3 year life and EBIT of $108,750 per year. Machine 2 costs $360,000, has a life of 6 years and EBIT of $122,875 per year. Assume straight line depreciation over the life of the machine. Marsh is a levered firm with a debt equity ratio of 0.40. The beta of equity is 1.125 while the beta of debt is 0.25. The market risk premium is 8 percent and the risk free rate is 5%. The corporate tax rate is 20%.

a.

b.

c.

2.

What is the firm’s cost of equity capital?

What is the firm’s weighted average cost of capital?

Which machine should Marsh purchase?

Advanced Technology is considering investing $38m to develop a gold mining site. The average equity beta of similar firms in the industry is 0.88. The market risk premium is 7% and the nominal risk free rate is 4%. Inflation is expected to be 2%.

a.

b.

Suppose there is a 20% chance of a low output of $2m and an 80% chance of a high output of $6m in the first year. If the output is low in the first year, there is a 70% chance that output will stay at $2m and a 30% chance that output will stay at $4m per year for the rest of the project’s life. However if the output is high in the first year, there is a 80% chance that it will stay at $6m and a 20% chance that it will stay at $3m per year for the rest of the project’s life of 10 years. These are real cash flows. Should the company go ahead with the project?

c.

3.

The site is expected to yield $6m in gold a year for 10 years. These are real cash flows. Suppose there is a 20% chance of no gold from the site and an empty site means zero cash flow and a complete loss of the $38m investment. What is the NPV of the project?

Would your conclusion in (b) be different if the company can abandon the mine for $36m in the event of low yield in the first year? Compute the value of the option to abandon.

“Aviation Biofuel” is considering setting up shop in Singapore. Their plan can be divided into 2 stages.

Stage 1: The project requires a test marketing expense of $20m. This test market is expected to last 1 year and there is a 60% chance of success.

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Stage 2: If the test market is a success, the firm intends to invest $100m in a plant. The after-tax cash flows will be $66m per year from year 2 to year 5. If the test market is a failure and the firm goes ahead with the investment, the NPV will be -$20m.

Assume a cost of capital of 17%.

a.

Draw the decision tree for this project.

b.

Estimate the NPV of Aviation Biofuel’s plan.

4.

You are asked to evaluate the following wooden cabinet manufacturing project for a corporation. Develop a table showing the annual cash flows and calculate the NPV of this project at an 8% discount rate. All figures are given in nominal terms.

20X6

Physical Production (cabinets)

Labor Input (hours)

Wood (physical units)

20X7

20X8

3,150

3,750

3,800

26,000

30,000

31,000

550

630

650

The required investment on 12/31/20X5 is $800,000. The firm faces a 34% income tax rate, and uses straight-line depreciation. The salvage value of the investment which will be received on 12/31/X8 will be one fifth of the initial investment. The price of cabinets on 12/31/X5 will be $250 each and will remain constant in the foreseeable future. Labor costs will be $15 per hour on 12/31/X5 and will increase at 5% per year. The cost for the wood will be $200 per physical unit on 12/31/X5 and will increase at 2% per year. Revenue is received and costs are paid at year's end (i. e. use year-end prices in calculating revenues and costs so, for example, use the 12/31/X6 prices for calculating 20X6 revenues and costs). The firm has profitable ongoing operations so that any losses for tax purposes from the project can be offset against these.

5.

Consider a project to supply Honda...