Handout #1

CORPORATE VALUATION

Spring 2011

You have $100,000 that you just inherited and are considering investing it in a new pick-up, compressor-tank spraying unit and associated equipment for your oil rig cleaning services company. The truck, spraying unit and equipment cost a total of $240,000 but you can come up with an additional $60,000 by selling your current truck and equipment to a competitor. The old equipment (including the truck) was purchased two years ago for $150,000 and is being depreciated using the MACRS depreciation schedule for 5-year assets (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%). You anticipate that the old truck will have a salvage value of $25,000 four years from now. The new truck will be depreciated using the same MACRS depreciation schedule for 5-year assets and you expect that the truck will have a resale value of $80,000 at the end of four years when you plan to replace it. Because the equipment uses hot water, you estimate that the improved service will increase revenues by $105,000 in the first year, increasing by 3% (the expected rate of inflation) per year thereafter. Your costs, however, will also go up by $50,000 in the first year, increasing at an 8% rate per year as the heating unit becomes less efficient and energy prices rise. Working capital requirements of $42,000 will accompany the acquisition of the new equipment, with additional increments of 3% per year (due to inflation), all of which will be recovered at the end of the fourth year. Your marginal tax bracket is 39%. Calculate the incremental cash flows of this investment project for each year. If your required rate of return is 12%, what is the Net Present Value of the investment? What is the Internal Rate of Return?

Year 0 Year 1 Year 2 Year 3 Year 4

Net Cash Flows (217,320) 39,778 54,947 42,271 134,600