# Capital Budgeting

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.

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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 the option to abandon. “Aviation Biofuel” is considering setting up shop in Singapore. Their plan can be divided into 2 stages. Stage 1: The project requires a test marketing expense of $20m.

This test market is expected to last 1 year and there is a 60% chance of success. FIN3101 Page1 Stage 2: If the test market is a success, the firm intends to invest $100m in a plant. The after-tax cash flows will be $66m per year from year 2 to year 5. If the test market is a failure and the firm goes ahead with the investment, the NPV will be -$20m. Assume a cost of capital of 17%. a. Draw the decision tree for this project. b. Estimate the NPV of Aviation Biofuel’s plan. 4. You are asked to evaluate the following wooden cabinet manufacturing project for a corporation.

Develop a table showing the annual cash flows and calculate the NPV of this project at an 8% discount rate. All figures are given in nominal terms. 20X6 Physical Production (cabinets) Labor Input (hours) Wood (physical units) 20X7 20X8 3,150 3,750 3,800 26,000 30,000 31,000 550 630 650 The required investment on 12/31/20X5 is $800,000. The firm faces a 34% income tax rate, and uses straight-line depreciation. The salvage value of the investment which will be received on 12/31/X8 will be one fifth of the initial investment.

The price of cabinets on 12/31/X5 will be $250 each and will remain constant in the foreseeable future. Labor costs will be $15 per hour on 12/31/X5 and will increase at 5% per year. The cost for the wood will be $200 per physical unit on 12/31/X5 and will increase at 2% per year. Revenue is received and costs are paid at year’s end (i. e. use year-end prices in calculating revenues and costs so, for example, use the 12/31/X6 prices for calculating 20X6 revenues and costs). The firm has profitable ongoing operations so that any losses for tax purposes from the project can be offset against these. . Consider a project to supply Honda with 38,000 tons of machine screws annually for automobile production. You will need an initial $1,596,000 investment in threading equipment to get the project started; the project will last for 6 years. The accounting department estimates that annual fixed costs will be $456,000 and that variable costs should be $220 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the 6-year project life.

It also estimates a salvage value of $506,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $262 per ton. The engineering department estimates you will need an initial net working capital investment of $547,000. You require a 13 percent return and face a marginal tax rate of 35 percent on this project. FIN3101 Page2 a. What is the estimated OCF and NPV for this project? b. Suppose you believe that the accounting department’s initial cost and alvage value projections are accurate only to within ±14 percent; the marketing department’s price estimate is accurate only to within ±9 percent; and the engineering department’s net working capital estimate is accurate only to within ±4 percent. What is your worst-case and best-case scenario for this project? c. Suppose that you are confident about your own projections, but you are not sure about the Honda’s actual machine screw requirements. What is the sensitivity of the project OCF to changes in the quantity supplied? What about the sensitivity of NPV to changes in quantity supplied?

Given the sensitivity you calculated, is there some minimum level of the output below which you would not want to operate? Why? 6. The Cornchopper Company is considering the purchase of a new harvester. The break-even purchase price is the price at which the project’s NPV is zero. The new harvester is not expected to affect revenues, but pretax operating expenses will be reduced by $13,300 per year for 10 years. The old harvester is now 5 years old, with 10 years of its scheduled life remaining. It was originally purchased for $48,300 and has been depreciated by the straight-line method.

The old harvester can be sold for $16,800 today. The new harvester will be depreciated by the straight-line method over its 10-year life. The corporate tax rate is 32 percent. The firm’s required rate of return is 13 percent. The initial investment, the proceeds from selling the old harvester, and any resulting tax effects occur immediately. All other cash flows occur at year-end. The market value of each harvester at the end of its economic life is zero. Determine the break-even purchase price in terms of present value of the harvester. FIN3101 Page3