Problems: First Group
Moeller- Corporate Finance
1. The genetic research firm, Splice and Dice, has created a project that will generate annual after tax cash flows of $41 million in perpetuity with an estimated return on assets of 17%. The rival firm, Replication, has created a project that will generate annual after tax cash flows of $45 million in perpetuity with an estimated return on assets of 19%. Both firms marginal tax rate is 34%.
a. Which firm has the better project? Why?
b. Replication has found a debtor who is willing to accept $2 million per year in interest payments for consol bonds (bonds in perpetuity). Replication believes that the riskiness of the interest tax shield is similar to its current cost of debt which is 10%. What is the new value of Replication? Does this change your decision?
2. Your company, a clothing manufacturer called Twisted Pair, is considering introducing a line of cargo pants made entirely from hemp. The project costs $4.6 million and will generate cash flows of $1 million for 5 years. Your boss asks you to estimate the following investment criteria: payback period, discounted payback, and NPV. Assume the company's pre-specified payback period is 5 years, the pre-specified discounted payback period is 4 years and the interest rate is 0.3% per month. Should the project be accepted? Why or why not?
3. Hollow Truth Publishers is considering whether to launch a new e-magazine. The annual rate of return on a similar risk project is 8%, the cash flows occur semi-annually (at the end of the 6th and 12th month), and the publishing company requires a payback period of 2 years. The finance department has calculated that the required rate of return for all projects that it will consider is 14%.
The costs of the project are:
Advertising on various billboards and cable television stations $210,000
Hollow Truth’s accounting department set up charges $ 50,000
Production costs and employee bonuses $250,000
Last years purchase price for the e-magazine's offices $470,000
Potential rental income from the offices if rented to a 3rd party $200,000
a. What are the total relevant costs of the project?
b. Assume the semi-annual cash inflows are $150,000 and $200,000 in year 1, and $250,000 and $200,000 in year 2. Calculate the payback, discounted payback, BCR, IRR and MIRR of the project. Based on each criterion, should you accept the project? Why?
c. If the project is analyzed using the NPV (net present value) rule, should you accept the project? Why? What would you do if you believed the semi-annual cash flows had a high degree of uncertainty and could be potentially 15% lower (You don’t actually have to re-estimate the NPV, just describe what you would do and how you would assess this)?
d. If you were the CEO of the firm, would you accept or reject this project? Why?
4. A new coffee company, Blink Inc., can grow its crops in Latin America (project a) or Africa (project b). Assume the projects are independent.
Project A costs $1.3 million and generates cash flows of $312,000 at the end of each of the next 5 years, $290,000 at the end of year 6, and $300,000 at the end of year 7.
Project B costs $2.2 million and generates cash flows of $480,000 at the end of each of the next 7 years.
a. Calculate the NPV for each project at the different costs of capital: 0.0%, 4.0%, 7.25%, 11.8651%, 14.5857% and 23%. Assume the cost of capital is given as an annual interest rate.
b. Using your answers from (a.), graph the NPV profiles for each project on one graph. (See the course packet for an example.)
c. Using the answers from parts (a.) and (b.), when should Blink Inc. grow crops in Latin America? Africa? Should the firm ever grow crops in both places? Neither place? Explain when and how you reached this conclusion.
d. Assuming you can only grow coffee beans in one location and your goal is to maximize shareholder wealth, when do you grow crops in Africa?
5. Answer the following questions comparing the IRR rule with the NPV rule:
a. What conditions must be satisfied for the IRR rule to result in the same decision as the NPV rule? What is the pitfall of the IRR if these conditions are not met?
b. Given the following table relating two mutually exclusive projects having conventional cash flows, identify:
1) The crossover rate
2) When Project A should be selected, when Project B should be selected and why
IRR / NPV at 3% / NPV at 6% / NPV at 9% / NPV at12%Project A / 7% / 17,900 / 16,400 / 0 / -4,200
Project B / 11% / 17,200 / 16,400 / 15,100 / 0
6. A project costs $2,500. It will generate after-tax cash flows of $840 per year for 12 years. The company likes to get paid back in 4 years and looks at projects with an estimated return of at least 14%.
a.) What is the project's payback period? Should you accept the project?
b.) If the interest rate is 12 percent per year, what is the discounted payback period? Should you accept the project?
c.) What is the IRR and MIRR of the project? Should you accept the project?
d.) What is the project's NPV? If you want to increase shareholders' wealth, should you accept the project?
7. As a manager of an electric utility you need to decide between building an oil-fired power plant or a coal-fired power plant. You will not build both plants. The table below presents the IRR and NPV for the different projects.
Type of Plant / IRR / NPV at 8.5%Oil-fired power plant / 15% / $22,567
Coal-fired power plant / 25% / $20,675
Which plant should you build? Why?
8. As a marketing manager of a local Blockbuster franchise you are analyzing a possible promotion in which customers of local take out pizza restaurants receive a Blockbuster video rental at half-price for every pizza pie they buy. You expect that the discount will induce more people to rent more Blockbuster videos. Market research evaluating the feasibility and expected profitability of the project cost $35,000. Promotional and advertising expenses equal $60,000. The promotion will run for eight weeks. You estimate that the project will generate after-tax cash flows of $8,000 per week. Your boss, who sets very high hurdles and likes projects that produce liquidity quickly, has specified that the payback period be four weeks. The appropriate discount rate is 0.25 percent per week. Given that you must use the payback rule with a cutoff period of four weeks, should you undertake the project? If you want to increase shareholder value, should you undertake the project? Explain.
9. A firm is considering an investment in a new manufacturing plant. The site already is owned by the company, but the existing buildings would need to be demolished. Which of the following should be treated as relevant (incremental) cash flows?
a. The market value of the site.
b. The market value of the existing buildings.
c. Demolition costs and site clearance.
d. The cost of a new access road put in last year.
e. Lost cash flows on the other projects due to executive time spent on the new facility.
10. As an intern at Geek Games, you are asked to evaluate a project that produces a new realtime interactive webgame. You estimate the sales price of the game to be $120.00 per game. Forecasted sales are estimated to be 46,000 games in year 1, 57,000 games in year 2, 32,000 games in year 3, 24,000 games in year 4, 20,000 in year 5, and 20,000 in year 6.
The variable costs associated with the producing a game are $60 per game in years 1 and 2, and $50 per game in years 3, 4, 5 and 6. The fixed costs are $350,000 per year. There was a $260,000 consulting fee for a feasibility study that concluded that the game was technically efficient. In addition, the project will require utilizing current employees for designing this game at a cost of $60,000 per year. The project requires an initial capital investment in computer equipment of $470,000. This equipment is 5-year modified ACRS (MACRS) and is expected to have a salvage value of 6% of cost after six years.
Net working capital requirements are $900,000 at the start (at time zero) of the project. After that, annual net working capital requirements are 15% of revenues. At the end of the project, all net working capital is recovered.
The tax rate is 34%, the project is entirely equity financed and the expected return on assets is 20%.
Should Geek Games proceed with the project?
11. The founder of Geek Games has decided to organize the new project as a stand alone firm which will aim for a target capital structure of 20% debt and 80% equity. Assume the amount of the firm’s equity and debt issue are based on the total value of the firm as calculated in the previous problem and the loan is an interest only loan (In other words there are no principle payments during the course of the project. The note is due at the end of the project.). Your investment banker estimates that your cost of debt will be 0.12 and the cost of equity will be 0.2216.
a.) What is the value of Geek Games considering the new capital structure? Assume that the riskiness of the interest tax shield is similar to the riskiness of the assets (see problem 10).
b.) What would be the value of Geek Games from part (a) if the only difference is that the riskiness of the interest tax shield is similar to the riskiness of the debt?
c.) From the shareholder’s perspective, what is the value of the new company?
12. As an intern at Nike, you are asked to evaluate a project that produces in-line skates. You estimate the sales price of a pair of skates to be $325.00 per pair. Forecasted sales are estimated to be 16,500 pairs in year 1, 22,500 pairs in year 2, 19,500 pairs in year 3 and 18,500 pairs in year 4.
You estimate that the variable costs associated with production are $165 per pair of skates. In addition, you estimate the erosion costs associated with the skates is $20 per pair. The firm also paid $100,000 in consulting fees for market research on the in-line skate market. Fixed costs in years 1 through 4 are $650,000 per year. The project requires an initial capital investment in equipment of $295,000. This equipment is 3-year modified ACRS (MACRS) and is expected to have a salvage value of 20 percent of cost after four years.
Net working capital requirements are $650,000 at the start of the project. After that, annual net working capital requirements are 20 percent of revenues. At the end of the project, all net working capital is recovered.
The tax rate is 34% and the required rate of return on the equity only financed project is 20%.
Should Nike proceed with the project?
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