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Solutions: ACT349 F13 Assignment for Sep 25, 2013 4:00pm Tutorial Brealey Myers Allen 11th Ed 'Principles

of Corporate Finance' (North American or Global edition)

For Sep 25 1Q on TT1 Chapter 5 1 a-e 3 5 7 8a-b 13 Chapter 6 1 3 21

1. (BMAGL11-XXX ;BMA11-Ch05-Q01 a, v00) C1

Solution Project A B C Payback period 3 yr 2 yr 3yr

(but C better than A)

(BMAGL11-XXX ;BMA11-Ch05-Q01 e, v00)

Solution True. Because it will be missing a lot of good long-term projects for which the payoff comes after more years

2. (BMAGL11-099 ;BMA11-Ch05-Q03v00)

Solution NPV = -6750 + 4,500/(1+i) + 18, 000/(1+i)2 i 0% 50% 100% NPV 15,750 4,250 0: so IRR=100%

t 0 1 2 Tot 6750 4500 18000

i 0 6750 4500 18000 15750

PV sttime 0at i i 0.5 1 6750 6750 3000 2250 8000 4500 4250 0

3. (BMAGL11-XXX ;BMA11-Ch05-Q05v00)

Solution: a): Two roots: solving a quadratic with b2 -4ac >0 so no problem with imaginary numbers. b) 0=75v2 -200v + 100

v = (200 +- sqrt(40,000 30,000))/(150) = (200 +_ 100)/(150) = 2 or 0.66666 Hence i= -50% or i+50% c) NPV (20%) >0 so, yes, an attractive project> A plot of NPV against i shows positive NPV if i within (-50%, +50%) Comment from Keith Sharp: This is assuming that the amazingly competent management can give a higher return on capital than the overall market can give. This gets pretty deep, and would involve considering e.g. that if the stockholder re-invests then he/she will be a marginal investor whereas the first few dollars of investment get the factory electricity turned on and give a big return. Getting beyond ACT349, dont worry about it.

4. (BMAGL11-XXX ;BMA11-Ch05-Q07v00)

Solution: The PI = NPV/Investment could be used as a guide. But its clear anyway that we dont want to spend out whole $90,000 on the unrewarding project 3, with PI=1/9. Going for projects 1, 2, 4, 6 uses exactly 90,000 gives us a NPV=5000+5000+15,000+3000=28,000 and is fairly clearly going to give us the highest NPV of any use of the 90,000 or less.

5. (BMAGL11-XXX ;BMA11-Ch05-Q08a)-b) v00)

Solution:

Project A B C

a) NPV <0 $4,045.73 $39.47

b) payback period 1 yr 2 yrs 4 yrs

so quick payback a lousy criterion here) NPV= -3000 + 1000 annuity5 (at 10%) 1000/1.103

6. (BMAGL11-XXX ;BMA11-Ch05-Q13 v00)

Solution: Consider the amount by which the revised cash flows differ 0 Original Revised Change 1 -250,000 -550,000 -300,000 2 -250,000 650,000 +900,000 3 650,000 -650,000

Looking at the change (increment), taking PV at time 1 NPV= - 650v2 +900v -300 0=13v2 -18v + 6 (so negative for very high interest rates)

(authors could have made this easy to factor but didnt, darn them)

v = ( 18 +_sqrt(18*18 4*13*6) / 26 i=21.13% or i= 78.87% NPV is positive only between 21.13% and 78.87%, so its only worth working the extra shift if the hurdke rate is betweeb 21.13% and 78.87%.
a: b: c: sqrt high root low root 13 18 6 3.464102 i 0.825542 0.559073 0.211325 0.788675

7. (BMAGL11-XXX ;BMA11-Ch06-Q01 v00) Which of the following should be treated as incremental cash flows when deciding whether to invest in a new manufacturing plant? The site is already owned by the company, but existing buildings would need to be demolished. a. The market value of the site and existing buildings b. Demolition costs and site clearance c. The cost of a new access road put in last year d. Lost earnings on other products due to executive time spent on the new facility e. A proportion of the cost of leasing the presidents jet airplane f. Future depreciation of the new plant g. The reduction in the corporations tax bill resulting from tax depreciation of the new plant h. The initial investment in inventories of raw materials i. Money already spent on engineering design of the new plant

Solution N (Already there) Y N (sunk) a. The market value of the site and existing buildings b. Demolition costs and site clearance c. The cost of a new access road put in last year

Y (opportunity coast) d. Lost earnings on other products due to executive time spent on the new facility N (paid anyway) N (not a cash flow) Y Y N (sunk) e. A proportion of the cost of leasing the presidents jet airplane f. Future depreciation of the new plant g. The reduction in the corporations tax bill resulting from tax depreciation of the new plant h. The initial investment in inventories of raw materials i. Money already spent on engineering design of the new plant

8. (BMAGL11-XXX ;BMA11-Ch06-Q03 v00) 3. Cash flows True or false?

a. A projects depreciation tax shields depend on the actual future rate of inflation. b. Project cash flows should take account of interest paid on any borrowing undertaken to finance the project. c. In the U.S., income reported to the tax authorities must equal income reported to shareholders. d. Accelerated depreciation reduces near-term project cash flows and therefore reduces project NPV.

Solution

a. A projects depreciation tax shields depend on the actual future rate of inflation. b. Project cash flows should take account of interest paid on any borrowing undertaken to finance the project. c. In the U.S., income reported to the tax authorities must equal income reported to shareholders. d. Accelerated depreciation reduces near-term project cash flows and therefore reduces project NPV.

F: IRS sets the rates F: generally get PV of project ignoring the financing method F F: usually gives you quick tax shields, which give you a positive cash flow

9. (BMAGL11-XXX ;BMA11-Ch06-Q21 v00) 21. Project NPV United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next years rental charge on the warehouse is $100,000, and thereafter the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.2 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of eight years and to resell the plant and equipment in year 8 for $400,000. Finally, the project requires an initial investment in working capital of $350,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7.Year 1 sales of hog feed are expected to be $4.2 million, and thereafter sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 35%. The cost of capital is 12%. What is the NPV of Pigpens project?

Solution by spreadsheet: (could use geometric series for some calcs but laborious)