Location via proxy:   [ UP ]  
[Report a bug]   [Manage cookies]                
Scribd
Upload
67 views

FIN5FMA Tutorial 4 Solutions

This document provides solutions to tutorial questions for a financial management course. It includes calculations and explanations for questions related to capital budgeting techniques, including net present value (NPV), internal rate of return (IRR), replacement chain analysis, equivalent annual annuity (EAA), and incorporating risk adjustments. It analyzes decisions around mutually exclusive projects and growth options. Key capital budgeting concepts like project cash flows, discount rates, depreciation schedules, and tax implications are considered in the multi-part questions.

Uploaded by

Maruko Chan
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
67 views

FIN5FMA Tutorial 4 Solutions

This document provides solutions to tutorial questions for a financial management course. It includes calculations and explanations for questions related to capital budgeting techniques, including net present value (NPV), internal rate of return (IRR), replacement chain analysis, equivalent annual annuity (EAA), and incorporating risk adjustments. It analyzes decisions around mutually exclusive projects and growth options. Key capital budgeting concepts like project cash flows, discount rates, depreciation schedules, and tax implications are considered in the multi-part questions.

Uploaded by

Maruko Chan
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

FINANCIAL MANAGEMENT (FIN5FMA), SEMESTER 1, 2015 –

SOLUTIONS TO ASSIGNED QUESTIONS FOR TUTORIAL 4

Problem 12-13 (Unequal lives)


Haley’s Graphic Design Inc. is considering two mutually exclusive projects. Both
projects require an initial investment of $10,000 and are typical average-risk
projects for the firm. Project A has an expected life of 2 years with after tax cash
inflows of $6,000 and $8,000 at the end of Years 1 and 2, respectively. Project B
has an expected life of 4 years with after-tax cash inflows of $4,000 at the end of
the next 4 years. The firm’s WACC is 10%.
a. If the projects cannot be repeated, which project should be selected if Haley
uses NPV as its criterion for project selection?

Project A

$6,000 $8,000
NPV  $10,000   $2,066 .12
1.10 (1.10) 2
Project B

 1  1 /(1.10) 4 
NPV  $10,000  $4,000   $2,679 .46
 0.10 
 

As the projects cannot be repeated, Project B should be selected because it has the
higher NPV.

b. Assume that the projects can be repeated and that there are no anticipated
changes in the cash flows. Use the replacement chain analysis to determine the
NPV of the project selected.

Application of the replacement chain (lowest common life) approach involves


replacing Project A at the end of it 2-year life with an identical project over years 3-4.
This allows a direct comparison of both projects over their lowest common 4-year
life.

Project A

$6,000 $8,000  $10,000 $6,000 $8,000


NPV  $10,000     $3,773.65
1.10 (1.10) 2 (1.10) 3 (1.10) 4

The NPV for Project B over the 4-year period (from Part a.) is $2,679.46. As such,
based on the replacement chain analysis, Project A should be selected over Project B
because it provides a higher NPV over the 4-year common-life period.

c. Make the same assumptions as in Part B. Using the equivalent annual annuity
(EAA) method, what is the EAA of the project selected?

Project A
1 1 /(1.10) 2
Annuity factor ( PVIFA 10%, 2 )  1.7355
0.10

EAA = NPV / PVIFA10%, 2 = $2,066.12 / 1.7355 = $1,190.50

Project B

1 1 /(1.10) 4
Annuity factor ( PVIFA 10%, 4 )  3.1699
0.10

EAA = NPV / PVIFA10%, 4 = $2,679.46 / 3.1699 = $845.28

Based on the EAA method, Project A would be selected as it has the highest EAA
value. This decision signal is consistent with that from the replacement chain
approach in Part b.

Problem 12-20 (Replacement analysis)


The Erley Equipment Company purchased a machine 5 years ago at a cost of
$90,000. The machine had an expected life of 10 years at the time of purchase,
and it is being depreciated by the straight-line method by $9,000 per year. If the
machine is not replaced, it can be sold for $10,000 at the end of its useful life. A
new machine can be purchased for $150,000, including installation costs. During
its 5-year life, it will reduce cash operating expenses by $50,000 per year. Sales
are not expected to change. At the end of its useful life, the machine is estimated
to be worthless. MACRS depreciation will be used, and the machine will be
depreciated over its 3-year class life rather than its 5-year economic life; so the
applicable depreciation rates are 33%, 45%, 15% and 7%. The old machine can
be sold today for $55,000. The firm’s tax rate is 35%. The appropriate WACC is
16%.
a. If the new machine is purchased, what is the amount of the initial cash flow at
Year 0?

Book value of existing machine = $90,000 – 5($9,000) = $45,000


Gain on disposal of existing machine = $55,000 - $45,000 = $10,000
Tax payable on disposal of existing machine = $10,000(0.35) = $3,500

Initial cash outflow associated with purchase of the new machine:

Purchase cost of new machine $150,000


Less Disposal proceeds from sale of existing machine 55,000
Add Tax payable on gain from disposal of existing machine 3,500
Initial cash flow (outflow) $98,500

b. What are the incremental net cash flows that will occur at the ends of Years 1
through 5?

This requires calculation of the depreciation allowances each year for the new
machine, and then using these to calculate the incremental cash flows from the
replacement of the new machine:
Depreciable Depreciation Depreciation Change in
Year MACRS % basis allowance allowance depreciatio
(new) (old) n
1 33% $150,000 $49,500 $9,000 $40,500
2 45% $150,000 $67,500 $9,000 $58,500
3 15% $150,000 $22,500 $9,000 $13,500
4 7% $150,000 $10,500 $9,000 $1,500
5 0% $150,000 $0 $9,000 -$9,000

Incremental net cash flows using the short-cut approach:

Year 1 NCF = ($50,000)(0.65) + ($40,500)(0.35) = $46,675


Year 2 NCF = ($50,000)(0.65) + ($58,500)(0.35) = $52,975
Year 3 NCF = ($50,000)(0.65) + ($13,500)(0.35) = $37,225
Year 4 NCF = ($50,000)(0.65) + ($1,500)(0.35) = $33,025
Year 5 NCF = ($50,000)(0.65) + (-$9,000)(0.35) – ($10,000)(0.65) = $22,850

Note
The $6,500 deduction in the Year 5 NCF represents the after-tax opportunity cost of
not being able to sell the old machine at the end of its useful life.

c. What is the NPV of this project? Should Erley replace the old machine?
Explain.

NPV = -$98,500 + $46,675/1.16 + $52,975/(1.16)2 + ($37,225)/(1.16)3 + $33,025/


(1.16)4 + $22,850/(1.16)5 = $34,073.20

Thus, the company should replace the existing machine with the new machine as the
incremental replacement NPV is positive.

Problem 13-5 (optimal capital budget)


Hampton Manufacturing estimates that its WACC is 12.5%. The company is
considering the following seven investment projects:

Project Size IRR


A $750,000 14.0%
B $1,250,000 13.5%
C $1,250,000 13.2%
D $1,250,000 13.0%
E $750,000 12.7%
F $750,000 12.3%
G $750,000 12.2%

a. Assume that each of these projects is independent and that each is just as risky
as the firm’s existing assets. Which set of projects should be accepted, and what
is the firm’s optimal capital budget?
As the projects are independent and have the same level of risk as the overall firm, the
company should select all of the projects which have an IRR greater than the firm’s
WACC of 12.5%. Thus, the firm should select projects A, B, C, D and E and its
optimal capital budget is the sum of the costs of these projects ($5,250,000).

b. Now, assume that Projects C and D are mutually exclusive. Project D has an
NPV of $400,000, whereas Project C has an NPV of $350,000. Which set of
projects should be accepted, and what is the firm’s optimal capital budget.

If projects C and D are mutually exclusive, then the firm can only select one of them
rather than both. Based on the NPV criteria, the firm should select Project D as it
provided a higher NPV (and also has a higher IRR). As a result, the firm’s capital
budget is now $4,000,000 and includes projects A, B, D and E.

c. Ignore Part b and assume that each of the projects is independent but that
management decides to incorporate project risk differentials. Management
judges Projects B, C, D and E to have average risk; Project A to have high risk;
and Projects F and G to have low risk. The company adds 2% to the WACC of
those projects that are significantly more risky than average, and it subtracts 2%
from the WACC of those projects that are substantially less risky than average.
Which set of projects should be accepted, and what is the firm’s optimal capital
budget?

Based on this risk-adjustment criteria:


 Required return (WACC) for Low-risk projects = 12.5% - 2.0% = 10.5%
 Required return for Average-risk projects = 12.5%
 Required return for High-risk projects = 12.5% + 2.0% = 14.5%

Low-risk projects
 Projects F and G will both be accepted because their IRRs (12.3% and 12.2%) are
greater than the required return of 10.5%

Average-risk projects
 Projects B, C, D and E will still be accepted because their IRRs are greater than
the firm’s average required return (WACC) of 12.5%

High-risk projects
 Project A will be rejected because its IRR of 14.0% is less than the required return
on high-risk projects of 14.5%

Thus, the selected projects are projects B, C, D, E, F and G and the firm’s optimal
capital budget is $6,000,000.

Problem 13-1 (growth option)


Martin Development Co. is deciding whether to proceed with Project X. The cost
would be $9 million in Year 0. There is a 50% chance that X would be hugely
successful and would generate annual after-tax cash flows of $6 million per year
during Years 1, 2, and 3. However, there is a 50% chance that X would be less
successful and would generate only $1 million per year for the 3 years. If Project
X is hugely successful, it would open the door to another investment, Project Y,
which would require an outlay of $10 million at the end of Year 2. Project Y
would then be sold to another company at a price of $20 million at the end of
Year 3. Martin’s WACC is 11%.
a. If the company does not consider real options, what is Project X’s NPV?
WACC = 11%; cash flows shown in millions.
0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
6 6 6 $5.662
-9
| | | -6.556
50% Prob. 1 1 1

Expected NPV = 0.5($5.662) + 0.5(-$6.556) = -$0.447 million. The


project would not be done.

b. What is X’s NPV considering the growth option?


If the project is hugely successful, $10 million will be spent at the end of Year 2, and
the new venture will be sold for $20 million at the end of Year 3.

0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
6 6 6
-10 +20 $12.170
-9 -4 26
| | | -6.556
50% Prob. 1 1 1

Expected NPV = 0.5($12.170) + 0.5(-$6.556) = $2.807 million.

c. How valuable is the growth option?


Value of growth option:
NPV with option $2.807 million
NPV without option - 0.000
+$2.807 million

You might also like