Exercise 1 - practice for the final

Period
0 1 2 3 4 a) Unlevered beta
FIXED ASSETS
Capital investment 28,000 8,000 ABC equity beta 0.8
Final sale of fixed assets 12,000 ABC E/(E+D) 4/5
Annual depreciation 6,000 7,000 7,000 7,000 ABC debt beta 0.3
WORKING CAPITAL ABC D/(E+D) 1/5
Accounts receivable 2,000.00 12,000.00 9,700.00 2,450.00 0 ABC asset (unlevered) beta 0.70
Accounts payable 1,500.00 12,250.00 7,400.00 800 0
Inventory 6,000.00 16,500.00 8,750.00 3,500.00 0 b) Cost of capital
SALES AND COSTS rf 2%
Sales 62,000.00 84,350.00 87,800.00 92,750.00 rm-rf 6%
Production costs 65,000.00 63,600.00 64,450.00 69,200.00 cost of capital 6.2%

a) Find the asset (unlevered) beta of ABC.

b) Find the cost of capital your company should use to value the project.
c) Find the expected cash flows of the project.
d) Find the project’s NPV and make a final decision about the project.

0 1 2 3 4
Capital investment 28,000 28,000 36,000 36,000 36,000
Liquidation value of capital assets 12,000
Cumulative depreciation 6,000 13,000 20,000 27,000
Book value of fixed asse 28,000 22,000 23,000 16,000 9,000
Working capital 6,500 16,250 11,050 5,150 0
Total book value 34,500 38,250 34,050 21,150 9,000
Sales 62,000 84,350 87,800 92,750
COGS 65,000 63,600 64,450 69,200
Depreciation 6,000 7,000 7,000 7,000

Periodo
0 1 2 3 4
Sales 62,000 84,350 87,800 92,750
COGS 65,000 63,600 64,450 69,200
Depreciation 6,000 7,000 7,000 7,000
EBIT 0 -9,000 13,750 16,350 16,550
Taxes (25%) 0 -2,250 3,438 4,088 4,138
NOPAT 0 -6,750 10,313 12,263 12,413
OCF 0 -750 17,313 19,263 19,413
WC cash-flow -6,500 -9,750 5,200 5,900 5,150
Capex -28,000 -8,000 11,250
FCF (12+13+14) -34,500 -10,500 14,513 25,163 35,813

NPV 17,642.02 --> go ahead with the project

IRR 18.74%
 Exercise 1 - practice for the final

Discount rate 6.20%

These are theory questions that should be answered with a bit of thinking and studying.

2) Explain what a project’s IRR is and the problems it may present as a criterion for investment decisions.

3) What is a sunk cost? Should it be included in the incremental cash flows for a project? Why or why not?

4) What is an opportunity cost?  Should it be included in the incremental cash flows for a project? Why or why not?
 Exercise 5 - Practice for the final

A company has to choose today between two different machines for the production of a new product. The two
machines have the same price. Machine A is more modern, but if the company abandons production of the product
the resale value of the machine would be zero. Machine B is a bit more standard, but it could be sold for an NPV of
9 million in case production were abandoned.
If demand is high, the company hopes to obtain an NPV of 14 million with machine A and 13 million with machine B
if production is not abandoned. If demand is low, these NPVs would be 6 (machine A) and 5 (machine B). The
probability of high demand is 55%. The company may decide to abandon production (and sell machine B) once the
demand has been observed to be high or low.
a) Solve the decision regarding what machine the company should buy today.
b) What is the value of the option of selling machine B?
c) What is the value for the company of knowing TODAY if demand is going to be high or low?

a) The optimal solution is using Machine B (11.20): see attached tree.

If the demand is high, we proceed with production; if low, abandon. If machine A is chosen, then always proceed.

b) The value without the option is 0.55*13+0.45*5=9.40

So the value of the option in the branch is 11.20-9.40=1.80, which is 0.45*(9-5)
From the point of view of the overall decision, the value of the option is 11.20-10.40=0.80, because if the option were not there, we would choose Machine A with

c) The value of that information is 0.55: see attached tree.

6) Your firm is planning to launch a new product. The demand for the product will depend on our marketing strategy
(which could be aggressive or neutral, but has to be decided today) and on the state of the economy (which will be good
with a 70% probability and bad with a 30% probability). After observing the state of the economy, the company may
decide not to produce and sell the assets for an NPV of 20. The NPVs of attending the demand in each situation are given
in the table below:
 a) Solve the decision tree.
b) What is the value of the probability of the “good state of the economy” which makes us indifferent between the two
alternative strategies?
c) If someone told you that he/she can predict the state of the economy with perfect accuracy, how much would you be
willing to pay for that information?
d) What is the value of the “option to sell” the project’s assets?

State of the economy

Strategy Good Bad
Aggressive 55 13
Neutral 35 25

a) The optimal solution is the aggressive strategy: see attached tree. If the economy is good, we proceed with production; if bad, we sell the assets.
If a Neutral strategy is chosen, then we never sell the assets.

b) We just need to solve the equation: 55p+20*(1-p)=35p+25*(1-p)

p*=20%

c) The value of that information is 1.5: see attached tree.

d) The value without the option is 0.7*55+0.3*13= 42.4

So the value of the option (both interpretations lead to the same answer) can be said to be 44.5-42.4=2.1, which is 0.3*(20-13)
 0 1 2 3
Capital investment 15,000 20,000
Liquidation value of capital assets 10,000
Working capital 2,500 3,000 4,000 10,000
Sales 1,308 20,000 50,000
COGS 2,093 19,323 48,880
Other operational costs 8,000 2,000 1,500 1,500

Period
0 1 2 3
1.a Capital investment 15,000 20,000
1.b Resale value of capital assets 10,000
1.c Gross value of capital assets 15,000 15,000 15,000 20,000
1.d Cumulative depreciation 0 3,750 7,500 5,000
1.e BOOK VALUE OF CAPITAL ASSETS 15,000 11,250 7,500 15,000
2 WORKING CAPITAL 2,500 3,000 4,000 10,000

4 Revenue (Sales) 0 1,308 20,000 50,000

5 COGS 0 2,093 19,323 48,880
6 Other operational costs 8,000 2,000 1,500 1,500
7 Depreciation 3,750 3,750 5,000
8 EBT (4-5-6-7) -8,000 -6,535 -4,573 -5,380
9 Taxes (0.25*8) -2,000 -1,634 -1,143 -1,345
10 NOPAT (8-9) -6,000 -4,901 -3,430 -4,035
11 + Depreciation 3,750 3,750 5,000
12.a Operating cash flow (10+11 or 4-5-6-9) -6,000 -1,151 320 965
12.b Changes in working capital -2,500 -500 -1,000 -6,000
12.c Capex -15,000 -10,625
12 Free cash flow (12.a+12.b+12.c) -23,500 -1,651 -680 -15,660
r 6.96%
NPV 4,232
IRR 10.0%
 4 5
7) You are given the following forecasts for a project’s
Book value Fixed assets are sold requirements and operational revenues and costs (in
15,000 0 Working capital is liquidatedrequires an initial investment of 15 million in PPE. Ho
100,000 85,000
at the end of year 3 these assets will be sold for a val
73,363 53,730
assets will need to be purchased. The cost of these ne
be 20,000. Depreciation of both purchases is going to
1,500 1,500
over four years, assuming a residual value of zero. Th
liquidated at the end of year 5: we are hoping that we
fixed assets at that moment for their book value. All p
the sale of fixed assets, are taxed at the regular rate o
enough profits in other lines of activity). The project
d to the other projects of the company. Our company is
4 5 our company’s equity is 1.2. The company’s capital st
and debt in a 70/30 proportion, respectively. The deb
5,000 considered risk-free. The current risk-free rate which
20,000 20,000 (given the project’s maturity) is 1.5%. The market risk
10,000 15,000 6.5%.
10,000 5,000
a) Compute the cost of capital of the project.
15,000 0
b) Compute NPV of the project.
c) At what value of the cost of capital will NPV becom
100,000 85,000
73,363 53,730
1,500 1,500
5,000 5,000 Careful here: if you depreciate the first fixed assets in the third year, the impact on the cash-flo
20,137 24,770 as if you do not. Think about it!
5,034 6,193
15,103 18,578
5,000 5,000
20,103 23,578
-5,000 15,000
5,000 Note that the Capex must be unaffected by whether you depreciate the fixed assets of 15,000
15,103 43,578 selling them.

a) Cost of capital

Equity beta 1.2

E/(E+D) 7/10
Debt beta 0
D/(E+D) 3/10
Asset (unlevered) beta 0.84

rf 1.5%
rm-rf 6.5%
cost of capital 6.96%
orecasts for a project’s investment
evenues and costs (in 000’s): the new project
f 15 million in PPE. However, you are told that
s will be sold for a value of 10,000 and new
d. The cost of these new assets is expected to
h purchases is going to be computed linearly
dual value of zero. The project is going to be
we are hoping that we can sell the remaining
their book value. All profits, including those in
ed at the regular rate of 25% (the company has
activity). The project under analysis is similar
mpany. Our company is public and the beta of
e company’s capital structure combines equity
respectively. The debt of our company is
nt risk-free rate which will apply to our project
1.5%. The market risk premium is taken to be

of the project.
apital will NPV become negative?

r, the impact on the cash-flow will be the same

e the fixed assets of 15,000 before

 Probability
of outcome
Type of of approval Cost of NPV of NPV of not
approval process application entering entering
No approval 20% -10 -- --
Reservations 30% 0 -5 0
No reservatio 50% 0 20 0

Enter 20
a) No reservations (50%)
Not enter 0

Market DC 8 Enter -5
Reservations (30%)
Not enter 0

No approval (20%) -10

Local market 6

Full Description of the strategy: Our company should try to enter the Market DC; if we get an approval with rese
if we get an approval without reservations, we enter.

b) The value of the option would be the difference between the expected value above (8) and the value without
Value without the option: Value of market DC=0.5*20+0.3*(-5)+0.2*(-10) 6.5

Therefore, the value of the option is 1.5, which is exactly 0.3 * (-5) (you avoid entering with reservations with 30

c) The value of that information takes into account that, if we knew the approval is going to say "NO" or "reserva
we would enter the Local market and make an NPV of 6.
If we know that approval is going to say "no reservations", then we go to Market DC and make an NPV of 20.
So value with information= 0.5*20+0.3*6+0.2*6= 13
Therefore the value of that information is 5, which is exactly (0.3*(6-0)+0.2*(6-(-10))
we get an approval with reservations, we should not enter the market;

ove (8) and the value without the option

ing with reservations with 30% probability).

going to say "NO" or "reservations", then

C and make an NPV of 20.