Practice Problem Set I

by Kyung Hwan Shim University of New South Wales Australian School of Business School of Banking & Finance for FINS 3625 S2 2012 October 27, 2012

These notes are preliminary and under development. They are made available for FINS 3625 S2 2012 students only and may not be distributed or used without the authors written consent.

Question 1 You are evaluating a project for The Ultimate recreational tennis racket, guaranteed to correct poor backhand strokes. You estimate the sales price of an Ultimate racket to be $400 and sales volume to be: 2,000 units in year 1; 2,250 units in year 2; and 2,650 units in year 3. The project has a life of three years; that is, after year 3 no further revenues are anticipated from this particular product line. Variable costs amount to $225 per unit and xed costs are $100,000 per year. The project requires an initial investment in machinery of $245,000. This machinery is in an asset class where the depreciation rate of 25 percent is done on a diminishing value method. The market value of the machinery at the end of year 3 is $55,000. The level of net working capital required each year must be equal to 20 percent of the next years sales. The rms tax rate is 34 percent, and the appropriate discount rate is 9 percent. Based on an NPV analysis, should the rm produce the Ultimate Tennis Racket? Explain all the steps taken to reach your conclusion: structuring of the problem and analysis should be explained in words as well as given by calculations. Simply providing a numerical answer is not sucient. Question 2 The True North Resource Company is considering a project that has the same risk as True Norths overall operations. True Norths capital structure consists of debt, preferred shares, and common equity. True Norths long-term debt has a face value of $1.25 million and an annual coupon rate of 15 percent. The bonds have 13 years remaining until maturity (a coupon payment was just made) and are currently priced in the market to yield 7.4 percent. True North has 5,700 preferred shares outstanding. The preferred shares each sell for $87.75 and pay a 7.9 percent dividend rate on a par value of $100. The total book value of True Norths common equity is $2.2 million; book value per share is $55. The stock sells for a price of $62.50 per share. The companys nancial manager estimates that the beta of True Norths common equity is 1.182. She has also determined that the current Treasury bill rate is 4.5 percent and that the expected rate of return on the market is 10 percent. True Norths corporate tax rate is 44 percent. (a) Calculate the market values and before tax required returns for True Norths debt, its preferred equity and its common equity. (b) Since True North is evaluating a new investment project that has the same market risk as the True Norths overall operations, calculate the rate True North should use to discount the projects cash ows. 2

(c) The True North Resource Company is considering a project that will generate perpetual before tax cash ows of $150,000 per year beginning next year. The project has the same risk as the rms overall operations. What is the most that True North can pay for the project and still earn its required return? Question 3 As a Financial Analyst at Jurassic Oil Company, you have been asked to evaluate the following project. Your company is determining whether or not it should drill an oil well in North-Eastern Australia. Your exploration geologists and accounting department have provided you with the following information: Drilling rights were obtained two years ago at a cost of $10,000. If the well is not drilled soon, these rights are lost. Drilling costs are expected to be $15,000. For tax purposes, these costs are 100% deductible in the following year. Pumping equipment required will cost $5,000 and is depreciable at a rate of 50% on a diminishing value method. Annual operating revenues (net of operating expenses) are expected to be $5,000 per year for the next 10 years. The pumping equipment is expected to have a salvage value of $1,000 at the end of year 10. Clean-up and site restoration costs are anticipated to be $1,000 (which are tax deductible) at year 10. The marginal tax rate of your oil company is 40%. The rms after-tax cost of capital is 15%. Should Jurassic Oil drill the well?

Questions 4 As a nancial manager at Woodstar Company, you consider building a new and improved production facility for one of your existing products. It would be built on a piece of vacant land that Woodstar owns. The land was purchased ve years ago at a cost of $2 million, and the land has now appreciated in value by 50%. The building can be erected for $1 million. Woodstar must invest $4 million in new machinery immediately, and can sell the old machinery for $1 million. Revenues generated by this improved production facility in each of the next four years are predicted to be as follows:

Year 1 2 3 Thereafter

Revenues $4,000,000 $2,000,000 $1,000,000

Expenses are expected to be 50 percent of revenues, and working capital required in each year is expected to be 10 percent of revenues in the following year. At the end of year 3, Woodstar intends to sell the building for $200,000 and the machinery for $2 million. The land will be sold for $5 million. Building and machinery fall into the same asset class and have a depreciation rate of 20 percent done on a diminishing value method. Woodstars tax rate is 40 percent and the companys cost of capital is 6 percent. Assume that 100% of capital gains are taxed as income. (a) Compute the initial investment for this project including all tax eects, but ignoring working capital. (b) Compute the value of cash ows from liquidation at the end of year 3, including all tax eects. (c) Calculate the NPV of this project, being sure to include all tax eects. Should Woodstar take on the project?