BA 340 Final review questions solutions 1. Degnan Dance Company, Inc.

, a manufacturer of dance and exercise apparel, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given. Existing Machine Proposed Machine _________________________________________________________________ Cost = $100,000 Cost = $150,000 Purchased 2 years ago Installation = $20,000 Depreciation using MACRS over Depreciation--the MACRS a 5-year recover schedule 5-year recovery schedule will be used. Current market value = $105,000 Five year usable life remaining Five year usable life expected Earnings Before Depreciation and Taxes Existing Machine Proposed Machine ________________________________________________________________ Year 1 $160,000 Year 1 $170,000 2 150,000 2 170,000 3 140,000 3 170,000 4 140,000 4 170,000 5 140,000 5 170,000 The proposed machine would be sold at book value at the end of the fifth year. The existing machine would be discarded after its remaining useful life if it was maintained. No working capital investment is required. The firms cost of capital is 10% and its tax rate is 40%. Should the new machine be purchased? Solution: Since we are evaluating just one project, we can use NPV. The required rate of return is 10% Incremental cash flows: Proposed machine: Initial cash flows: Purchase price + installation = $170,000 Operating cash flows: Using a 5-yr MACRS schedule, depreciation for the proposed machine for 5 years is: Yr. 1: 170000 * 0.2 = 34000 2: 170000 * 0.32 = 54400 3: 32640 4: 19580 5: 19580 OCFs: EBDepr - Depr EBIT -taxes +Depr Yr 1 170000 34000 136000 54400 34000 2 170000 54400 115600 46240 54400 3 170000 32640 137360 54948 32640 4 170000 19580 150420 60168 19580 5 170000 19580 150420 60168 19580

OCF Terminal cash flow:

115600

123760

115052

109832

109832

Sale of proposed machine (at book value): Book value = 170000 34000 54400 32640 19580 19580 = 9800 Existing machine: Sale of existing machine (included in initial cash flows): Book value = 100000 (100000 * 0.2) (100000 * 0.32) = 48000 Cash flow from sale: 105000 (105000 48000) * 0.4 = 82200 Operating cash flows lost: The existing machine is to be used for 5 more years: Depreciation: Yr. 1: 2: 3: 4: 5: OCFs: EBDepr - Depr EBIT -taxes +Depr OCF Yr 100000 * 0.192 = 19200 100000 * 0.1152 = 11520 100000 * 0.1152 = 11520 100000 * 0.0576 = 5760 0 1 160000 19200 140800 56320 19200 103680 2 150000 11520 138480 55392 11520 94608 3 140000 11520 128480 51392 11520 88608 4 140000 5760 134240 53696 5760 86304 5 140000 0 140000 56000 0 84000

NPV: (-170000 + 82200) + (115600 103680)/1.1 + (123760 94608)/1.1^2 + (115052 88608) / 1.1^3 + + (109832 + 9800 84000) / 1.1^5 = 5191 ACCEPT. (109832 86304)/1.1^4

2. Galaxy Satellite Co. is attempting to select the best group of independent projects competing for the firm's fixed capital budget of $10,000,000. All four projects have conventional cash flows. The firms cost of capital is 20%. A summary of key data about the proposed projects follows. Project ------Initial Investment -----------------IRR --PV of Inflows at 20% -------------

A B C D E F What should the firm do?

$3,000,000 9,000,000 1,000,000 7,000,000 4,000,000 6,000,000

21% 25 24 23 19% 21%

$3,150,000 9,320,000 1,040,000 7,350,000 3,875,000 6,500,000

Solution: For this question we can use either the profitability index or NPV of a combination of projects such that the total investment is 10 million (budget) or less. Since PI is the present value of benefits divided by the present value of costs, we can simply divide PV of inflows by the initial investment to obtain PI for each project: PI for A: B: C: D: E: F: 3150000 / 3000000 = 1.05 9320000 / 9000000 = 1.036 1040000 / 1000000 = 1.04 7350000 / 7000000 = 1.05 3875000 / 4000000 = 0.969 6500000 / 6000000 = 1.08

All but project E is acceptable. Ranks: F, A and D (tied), C, B. We will have used up our 10 million dollar budget exactly by investing in projects F, A and C. Although D is ranked ahead of C we do not have the capital to invest in D. 3. Cuda Marine Engines, Inc. must decide whether a capital investment (new equipment) proposal is worthwhile. The firm has spent $15,000 developing the technology that will be applied to the new equipment. The proposed asset costs $50,000 and has installation costs of $3,000. The equipment will be housed in a facility that is owned by the firm but that is currently not being used. This facility is currently worth $10,000. The new equipment will be depreciated using a five-year recovery schedule, is expected to be used for 3 years after which it will be sold for $20,000. The new equipment is expected to generate revenues of $25,000 and operating expenses of $10,000 annually. It also requires an investment in inventory of $10,000. No other current accounts are expected to be affected. The firm has a 40 percent tax rate. If the required rate of return for this proposal is 15%, should Cuda go through with it? Solution: Done in class. 4. A corporation is considering a capital project for the coming year. The project has an internal rate of return of 14 percent. If the firm has the following target capital structure and costs, what should their decision be and why? Source of Capital Proportion After-tax cost __________________________________________________ Long-term debt .40 10 % Preferred stock .10 15 % Common stock equity .50 20% Solution: We need to compare the IRR of the project to the WACC. The WACC is: 0.4 * 10% + 0.1 * 15% + 0.5 * 20% = 15.5%. Since IRR < WACC, we would reject the project. 5. Kottinger's Kamp Supplies is considering an investment in new manufacturing equipment. The equipment costs $220,000 and will provide annual aftertax inflows of $80,000 at the end of each of the next

four years. No terminal cash flows are expected. The firm's proportion of its capital structure that is debt is 25%. The remainder is common equity. The firms beta is 1.4, and its pretax cost of debt is based on the firms outstanding debt: Current price = $1040, Maturity = 15 years, Annual coupon rate = 7% (paid semiannually). The current risk-free rate is 4% and the market return is 8%. 1. 2. Assume the project is of approximately the same risk as the firm's existing operations. Should the firm invest? Assume instead that KK is a multi-division firm with operations in Manufacturing, Travel Services, Retail Stores Rentals. Use the following information to determine whether the project should be accepted. Firm Stanton Xenox Trail Mix Industry Retail Travel Services Manufacturing Beta 1.3 0.7 2.2

Each of the firms above only operates in the industry indicated. Solution: I did not provide you with a tax rate for this question. One is needed. Assume it is 35%. 1. For the first question, we can use the firm WACC to assess the project Re = 4% + 1.4 * (8% - 4% ) = 9.6% We can come up with an approximate value for the before-tax cost of debt using the firms outstanding debt information:

70 +
Rd =

1000 1040 15 = 6.6% 1000 + 1040 2

WACC = 0.75 * 9.6% + 0.25 * 6.6% * (1 0.35) = 8.27% The NPV of the project is: NPV = -220 80/1.0827 - 80/1.0827^2 Project is acceptable. 2. For the second question, we need to determine a project-specific WACC. Since the project is in manufacturing, we can use Trail Mixs beta to compute a cost of equity and WACC for the project. Trail Mix represents a pure play firm for evaluating the project. Re for project: 4% + 2.2 * (8% - 4%) = 12.8% WACC = 0.75 * 12.8% + 0.25 * 6.6% * (1-0.35) = 10.67% NPV = -220 80/1.1067 - 80/1.1067^2 Project is still acceptable. - 80/1.1067^3 - 80/1.1067^4 = 29955 - 80/1.0827^3 - 80/1.0827^4 = 43,485

6. Which of the following firms will benefit from an increase in debt in their capital structure? The firms tax rate is 35% Firm A B C D E Beta 1.3 1.1 2.1 0.8 0.5 Cost of equity 11.5 10.5 15.5 9.0 7.5 Return on Equity Before Tax cost of debt 20% 7% 15% 13% 13% 10% 7% 8% 6% 10%

Solution: Firms will benefit by adding debt if their return on equity is greater than their after-tax cost of debt. Firm A B C D E ROE 20% 15% 13% 7% 6% AT cost of debt 7% * (1-0.35) = 4.55% 13% * (1-0.35) = 8.45% 10% * (1-0.35) = 6.5% 8% * (1-0.35) = 5.2% 10% * (1-0.35) = 6.5% BENEFIT BENEFIT BENEFIT BENEFIT WILL NOT BENEFIT