BA 2802 – Principles of Finance

Solutions to Problems for Recitation #5

1. XYZ Company is not distributing any dividends right now. Investors expect this firm to
start distributing dividends in the future. The first dividend of the company is expected
to be $1.5 per share and distributed in exactly 4 years from today. Then the dividends
of this company are expected to grow at 30% for the first 2 years and at 15% for the
next 2 years and at 6% forever thereafter. Investors want to earn a return of 12% on
their investment in this stock.
a Calculate the value of XYZ Company shares today.
b. Calculate the value of XYZ Company shares 5 years from today.

2. The ABC Company is thinking about investing in a project, project A. The summary of
cash flows from the project A is given below. The required rate of return for the projects
at the same risk level is 10 percent.

Time Cash Flows

0 -$11,000
1 -39,000
2 440,180
3 217,520
4 -2,000
a. Compute the NPV and decide to accept or reject the project.
b. Compute the IRR and decide to accept or reject the project.
c. Compute the MIRR by using discounting, reinvestment and combination
approaches and decide to accept or reject the project.
d. After calculating NPV, IRR and MIRR briefly discuss which method should be
used in this project as a decision criteria.

3. B. Davis Industries must choose between gas-powered and electric-powered forklift

truck for moving materials in its factory. Since both forklifts perform the same function,
the firm will choose only one. The electric-powered truck will cost $22,000, whereas
the gas-powered truck will cost $17,500. The required return for both projects is 12
percent. The life for both types of truck is estimated to be 6 years, during which time
the annual operating cash flows for the electric-powered truck will be $6,290 per year
and those for the gas-powered truck will be $5,000 per year.
a. Calculate the NPV and IRR for each type of truck
b. Decide which forklift to recommend.

4. The MegaCuts company purchased a paper cutting machine for $600,000 four years
ago. Now, it is considering replacing this machine with a new one in order to reduce its
costs. For tax purposes, the firm was going to depreciate the old machine to a salvage
value of 0 over 6 years. This machine can be used in the production for another four
years. The operating costs are $175,000 per year. This machine can be sold today for
$325,000. At the end of its economic life (i.e., at the end of year 4), the firm estimates
that this machine can be sold for $50,000. The new cutting machine will cost the firm
$750,000 today, and will be depreciated towards a salvage value of 0 in four years. This
machine can be used for four years in the production process. At the end of year 4, it
can be sold for $250,000. The operating costs of this machine will be $50,000 per year
 (a cost reduction of $125,000 per year). Since the new machine will break down for
fewer times, the firm does not have to carry as much inventory as it does with the old
machine. Therefore, the inventory level is estimated to decline by $5,000 at t=0 and by
another $15,000 at t=1. Last year, the firm spent $25,000 to test the new machine in its
production process. The firm is in 34% tax bracket. The MegaCuts’cost of capital is
11%.
a. Calculate the initial investment at t=0, operating cash flows at t=1, 2, 3, 4 and
the termination cash flows at t=4.
b. Determine whether the MagaCuts should replace its paper cutting machine or
not.

5. You are trying to pick the least-expensive car for your new delivery service. You have
two choices: the Scion xA, which will cost $15,000 to purchase and which will have
OCF of -$1,200 annually throughout the vehicle’s expected life of three years as a
delivery vehicle; and the Toyota Prius, which will cost $20,000 to purchase and which
will have OCF of -$650 annually throughout that vehicle’s expected four year life. Both
cars will be worthless at the end of their life. Your business has a cost of capital of 12
percent.
a. If you intend to replace whichever type of car you choose with the same one
when its life runs out, again and again forever decide which one you should
choose.
b. If this is a one time decision and you will not replace the car with the same model
forever than decide which car to choose.

6. The Campell Company is evaluating the proposed acquisition of a new milling machine.
The machine’s base price is $108,000, and it would cost another $12,500 to modify it
for special use by your firm. The machine falls into the MACRS 3-year class, and it
would be sold after 3 years for $65,000. The machine would require an increase in
inventory of $5,500 at t=0. The milling machine would have no effect on revenues but
it is expected to save the firm $44,000 per year in before-tax operating costs, mainly
labor. Campbell’s marginal tax rate is 35 percent.
a. Calculate the relevant cash flows
b. Decide whether the machine should be purchased if the project’s required rate
of return is 12 percent.