Chapter 6 and 7

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Problems/Answers: FIN 534
I have provided the answers to Chapters 6 and 7, you are to provide the solutions and explanations, namely, how were you able to determine the same answers. I want to see, how you go about solving these problems. I would encourage you to use the MyFinanceLab and go over the previous Chapters. Keep in mind that these responses are due, November 1, 2010. I will use your submission to grade you and not the group work that you did in class, last Thursday. I trust that you will find this helpful. Also, provide all submissions to the dropbox. I am in the process of setting it up. So give me until Monday before you start with your submission. MY QUESTIONS WILL BE IN BOLD CAPS. Chapter 6:

Problem 3: 6-3.You are considering opening a new plant. The plant will cost $100 million upfront. After that, it is expected to produce profits of $30 million at the end of every year. The cash flows are expected to last forever. Calculate the NPV of this investment opportunity if your cost of capital is 8%. Should you make the investment? Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged. Timeline:

Yes, make the investment. HOW DID YOU COME TO THIS CONCLUSION: SHOW FORMULA? IRR: = 30%. HOW DID YOU COME TO THIS CONCLUSION?
SHOULD YOU MAKE THE DECISION AND WHY?

Problem: 13 6-13.Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for 10 years. The company will have to provide product support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year. a.What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rates of 2% and 12%. b.How many IRRs does this investment opportunity have?

c.Can the IRR rule be used to evaluate this investment? Explain. a.Timeline:
r = $693,420.38
r = –$1,017,414.99
r = –$183,110.30
HOW DID YOU COME TO THESE CONCLUSIONS?
b.From the answer to part (a) there are 2 IRRs: 2.745784% and 10.879183% HOW DID YOU MAKE THIS DETERMINATION?
c.DOES THE IRR RULE APPLY? EXPLAIN.

Problem 24: 6-24.You work for an outdoor play structure manufacturing company and are trying to decide between two projects:
You can undertake only one project. If your cost of capital is 8%, use the incremental IRR rule to make the correct decision. Timeline:
012

Playhouse –301520
Fort –803952
Subtract the Playhouse cash flows from the Fort
–502432

Solving for r WHAT FORMULA DID YOU USE TO DETERMINE RATE?

Since the incremental IRR of 7.522% is less than the cost of capital of 8%, SHOULD YOU TAKE THE PLAYHOUSE? EXPLAIN. .

Chapter 7:
Problem 3: 7-3.Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store.

Which of the following should be included as part of the incremental earnings for the proposed new retail store? a.The cost of the land where the store will be located.
b.The cost of demolishing the abandoned warehouse and clearing the lot. c.The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead. d.The $10,000 in market research spent...
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