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Note: Where appropriate, the nal answer for each problem is given in bold italics for those not interested in the discussion of the solution. I. Formulas This section contains the formulas that you will need for this homework set: 1. Present Value of an Annuity Formula: A0 = a a a a + + ... + + 2 N 1 (1 + i) (1 + i) (1 + i) (1 + i)N 1 (1 + i)N = a i

(1)

where a is the amount of the annuity payment, i is the periodic interest rate and N is the total number of compounding periods. 2. Present Value of a Perpetuity Formula: A0 = a a a + + + ... 2 (1 + i) (1 + i) (1 + i)3 a = i (2) (3)

II. 1.

Problems

1.a The present value of the cash ows (in $thousands) to both machines for one operating cycle are: N P VM achine A = 80 + N P VM achine B 50 50 50 25 + = 61.42 2 + 3 + 1.1 (1.1) (1.1) (1.1)4 60 60 60 = 100 + + = 49.21 2 + 1.1 (1.1) (1.1)3

In order to compare these investments, we must now compute their equivalent annuity payments. From the annuity formula (equation (1)) we have a = PV For machine A, a = 61.42 For machine B a = 49.21 0.10 = 19.788. 1 (1 + 0.10)3 0.10 = 19.376. 1 (1 + 0.10)4 i 1 (1 + i)N .

Therefore, machine B is the better choice. 1.b Using the results above, we can consider the value of each machine used in perpetuity. N P VM achineA = N P VM achineB 19.376 = 193.76. 0.1 19.788 = = 197.88. 0.1

Thus, over the entire lifetime, machine B will provide the company with $197.88 $193.76 = $4.12 additional thousands of dollars. The up front cost of $10,000 for machine B negates this advantage, implying that we should choose machine A under this scenario. 2

1.c They should replace the existing machine as soon as its annual cash ows fall below the annual equivalent of its replacement. This occurs in year 3. 1.d Comparing one-year annual equivalent cash ows produces the correct answer regardless of the time-horizon. Thus, without the re-tooling fee of $10,000 on machine B, we should choose machine B. The aggregate NPV of both machines is now (using the perpetuity formula in equation (3)): N P VM achineA = 19.376 N P VM achineB 1 (1 + 0.10)24 ) = 174.09 0.1 1 (1 + 0.10)24 ) = 19.788 = 177.79 0.1

Therefore, with the re-tooling fee for machine B, we should choose machine A. 2. The rst step is to determine the cash ows and their timing, which are outlined in Table 1 Table 1: Year EBITDA Depreciation EBIT Tax Salvage Value Cost Total Cash 0 1 0 11,000 0 -6,000 0 5,000 0 -1,700 0 0 -60,000 0 -60,000 9,300 Flows ($) 2 ... 8 11,000 ... 11,000 -6,000 ... -6,000 5,000 ... 5,000 -1,700 ... -1,700 0 ... 12,000 0 ... 0 9,300 ... 21,300

Depreciation is computed using a straight-line (interpolated) method, which amounts to computing the average value loss per year ((60, 000 12, 000)/8 = 6, 000). The tax gures are computed assuming a 34% marginal 3

corporate tax rate (5, 000 0.34 = 1, 700). The nal cash ows are obtained by subtracting the tax from the EBITDA (depreciation is not a cash outow). The next step is compute the present value of these cash ows: $60, 000 + $9, 300 1 (1 + 0.12)8 $12, 000 + = $8, 954.35 0.12 (1.12)8 (4)

We reject the project since it has a negative NPV. 3. The maximum amount that we would be willing to pay for the machine is the price such that the NPV is equal to zero (at which point we would be indierent between purchasing and not purchasing the machine). Since the purchase price determines the depreciation, salvage value and tax expense, we cannot simply adjust the $60,000 gure from equation (4) until the NPV is driven to 0. There are several ways to solve this problem. The rst is simply a trial and error method (that can be automated by using GOALSEEK in Excel). The other, more elegant and useful way, is to derive an expression for the NPV of the machine in terms of the purchase price (P rice) of the machine and solve for the price that sets NPV = 0. The NPV of the machine may be expressed as:

8

N P V = P rice +

t=1

(5)

The cash ow in any period t are: Cash Flowt = EBIT DAt 0.34(EBIT DAt Depreciation) Substituting 11,000 for the value of EBIT DAt yields Cash Flowt = 7, 260 + 0.34 Depreciation. The depreciation in any period may be expressed as: Depreciation = (P rice Salvage Value)/Life Span = (P rice 12, 000)/8 4 (6)

(7)

Substituting equations (6), (7) and known values for r and Salvage Value into equation (5) yields:

8

NP V

= P rice +

t=1

1 (1 + 0.12)t

7, 260 + 0.34

8

NP V

= P rice +

t=1

t=1

0.0425 (1.12)t

t=1

+ 4, 846.60 Using our annuity formula, we can evaluate the summation terms as:

8

t=1 8

7, 260 1 (1.12)8 = 7, 260 = 36, 065.0647 (1.12)t 0.12 0.0425 1 (1.12)8 = 0.0425 = 0.2111 (1.12)t 0.12 510 1 (1.12)8 = 510 = 2, 533.4963 (1.12)t 0.12 (10)

t=1 8

t=1

Setting N P V = 0 and solving for P rice in equation (11) yields $48,647.70 (your answer may dier by up to several dollars due to rounding). 4. 4.a The cash ows are detailed in Table 2. The depreciation gure follows from the straight-line method (25,000/8 = 3,125) and the tax follows from a 34% marginal tax rate (1, 375 0.34 = 467.50). 5

Table 2: Year Cost Savings Depreciation Increase in Taxable Income Tax (34%) Investment Total Cash 0 1 0 4,500 0 -3,125 0 1,375 0 -467.50 -25,000 0 -25,000 4,032.50 Flows ($) 2 4,500 -3,125 1,375 -467.50 0 4,032.50 ... 8 ... 4,500 ... -3,125 ... 1,375 ... -467.50 ... 0 ... 4,032.50

Given the cash ows, we now need to nd the NPV: N P V = 4, 032.50 1 (1 + 0.12)8 25, 000 = $4, 967.99. 0.12

Since this gure is less than zero, we reject the project. 4.b The cash ows are under the leasing scenario are shown in Table 3. Table 3: Year Cost Savings Lease Payments Pre-tax Revenue Tax (34%) After-tax Cash Flows The NPV of these cash ows is 1 (1 + 0.12)8 N P V = 330 = $1, 639.32 0.12 0 0 0 0 0 0 Cash Flows ($) 1 2 ... 4,500 4,500 ... 4,000 4,000 ... 500 500 ... -170 -170 ... 330 330 ... 8 4,500 4,000 500 -170 330

Table 4: Year Cost Savings Depreciation Increase in Taxable Income Tax (34%) Investment Total Cash Flows ($) 0 1 2 ... 8 0 4,500 4,500 ... 4,500 0 -1,250 -1,250 ... -1,250 0 3,350 3,350 ... 3,250 0 -1,105 -1,105 ... -1,105 -10,000 0 0 ... 0 -10,000 3,395 3,395 ... 3,395

4.c The cash ows are shown in Table 4. The NPV of these cash ows is N P V = 3, 395 1 (1 + 0.12)8 10, 000 = 6, 865.14 0.12

The maximum lease payment we would be willing to make is one that sets the NPV to 6,865.14. The yearly cash ows from the lease strategy are given by: Cash Flow = (1 0.34)(4, 500 Lease Payment) Therefore, the maximum lease payment solves: 6, 865.14 = (1 0.34)(4, 500 Lease Payment) 1 (1.12)8 0.12

which implies Lease Payment = $2, 406.10. Any payment greater than this amount and we would prefer to buy. Any payment less than this amount and we would prefer to lease. 5. The approach for solving this problem is to compute the NPV for each replacement strategy and then compare the annual equivalent for each strategy, choosing the largest amount. One Year Replacement The cash ows are in Table 5 The NPV of these cash ows is $8,400/1.12 - $15,000 = -$7,500. 7

Table 5: Year Maintenance Costs Depreciation Reduction in Tax Income Tax Benet Salvage Cost Total Table 6: Year Maintenance Costs Depreciation Reduction in Tax Income Tax Benet Salvage Cost Total Cash Flows 0 1 0 -1,000 0 -6,000 0 -7,000 0 2,380 0 0 -15,000 0 -15,000 1,380 ($) 2 -2,000 -6,000 -8,000 2,720 3,000 0 3,720 Cash Flows ($) 0 1 0 -1,000 0 -9,000 0 -10,000 0 3,400 0 6,000 -15,000 0 -15,000 8,400

Two Year Replacement The cash ows are in Table 6 The NPV of these cash ows is $1, 380/1.12 + $3, 720/1.122 $15, 000 = $10, 802. Three Year Replacement The cash ows are in Table 7 The NPV of these cash ows is $1, 040/1.12 + $380/1.122 280/1.123 $15, 000 = $13, 967.

Table 7: Year Maintenance Costs Depreciation Reduction in Tax Income Tax Benet Cost Total Cash Flows ($) 0 1 2 0 -1,000 -2,000 0 -5,000 -5,000 0 -6,000 -7,000 0 2,040 2,380 -15,000 0 0 -15,000 1,040 380 3 -3,000 -5,000 -8,000 2,720 0 -280

The annual equivalents (AE) for each of these cash ows are: 0.12 = 8, 400 1 (1.12)1 0.12 AE2 = 10, 802 = 6, 392 1 (1.12)2 0.12 AE3 = 13, 967 = 5, 815 1 (1.12)3 AE1 = 7, 500 Hence, option 3 gives the lowest per-year operating cost and is thus, the best strategy of the three. 6. 6.a The IRR is found by solving the following equation: 0 = 575 + 500 500 + , (1 + IRR) (1 + IRR)2

which is quadratic in IRR. The solution may be found by applying the quadratic formula to get IRR = 46%.1 Since the IRR is greater than the 25% required rate of return, we should accept the project. This is the correct decision rule in this case since there is only one sign change in the cash

1

ow stream. Thus, the IRR rule and the NPV rule coincide. As a check, the NPV of the project is: 575 + 500 500 + = 145, (1.25) (1.25)2

which is greater than 0, implying that we should accept the project. 6.b The IRR for the new cash ow stream is found by solving the following equation: 0 = 500 + 500 575 1100 , . 2 (1 + IRR) (1 + IRR) (1 + IRR)3

This equation can be solved in closed form or numerically in Excel. The resulting IRR is 27% implying that the project should be accepted. However, computation of the NPV shows N P V = 500 + 500 575 1100 = 31.2 2 (1.25) (1.25) (1.25)3

leading to a rejection of the project.(See Brealey and Myers, 7th Ed., Pages 98-99 for a discussion of the discrepancy) 7. There are two approaches to solving this problem. The rst compares the NPV for starting the project now versus waiting and compares NPVs. The second subtracts the cash ows for the start now alternative from the cash ows of the start in 3 years alternative and computes the NPV of those incremental cash ows. We take the latter approach (the Excel solutions contain both approaches). Table 8 shows the incremental cash ows.

where a,b and c are constants. The quadratic formula shows that the solution to this equation is: b + b2 4ac x= (12) 2a We can algebraically rearrange equation (12) to get 575(1 + IRR)2 + 500(1 + IRR) + 500 = 0 implying that a = 575, b = 500 and c = 500. Substituting these values into equation (12) yields two solutions, 0.46 and -1.59. Since -1.59 is not a realistic discount rate, we choose 0.46.

10

11

8. Incomplete. See Excel Solutions 9. If the rm considers the cash ows from the rst generation product then it is indierent between the two projects. Nevertheless, building plant two is the correct decision (see Table 9). Note that both projects have about the same NPV in terms of the expected cash ows from each. The characteristic that distinguishes plant 2 is the fact that this project provides management with an option to enter the market for the second generation product which is not provided with plant 1. This real option intrinsically has some non-zero value, hence plant 2 is the preferred alternative.

12

Table 8: 0 3,000 -150 1,000 119 2,031 1.000 2,031 -85 -765 1.160 -659.48 -85 -765 1.346 -568.52 -150 1,000 -150 1,000 1 Cash Flows ($) 2 3 -600 4 -600 1.561 1.811 -384.39 ... T (1.016)T -

13

Increase(Decrease) In Taxes Owed Increase(Decrease) In Net Cash After Taxes Discount Factor Increase(Decrease) In Present Value

These solutions are produced by Michael R. Roberts. Thanks go to Jen Rother for her excellent assistance, and to an anonymous TA. Any remaining errors are mine.

14

Table 9:

15

Cash Flows ($) 0 1 2 3 4 -3,322 1,776.50 1,397 996.60 554.40 -4,286.70 772.30 1,236.40 1,762.20 1,549.90 1.000 1.150 1.323 1.521 1.749 -3,322 1,544.78 1,056.33 655.28 316.98 -4,286.70 671.57 934.90 1,158.68 886.16 347.08 347.11 5 145.20 1,217.70 2.011 72.19 605.41

6 7 8 42.90 13.20 666.60 236.50 2.313 2.660 18.55 4.96 288.19 88.91

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