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