BA 2802 – Principles of Finance

Solutions to Problems for Recitation #5

| g1=30% | g2=15% | g3=6%

1) |----------|----------|----------|----------|----------|----------|---------|-----------|----------|----------|-------
D4 D5 D6 D7 D8 D9 D10 D11 D12
r=12%

a. D4 = $1.5
D5 = D4(1+g1) = 1.5(1+0.30) = $1.95
D6 = D5(1+g1) = 1.95(1+0.30) = $2.535
D7 = D6(1+g2) = 2.535(1+0.15) = $2.915
D8 = D7(1+g2) = 2.915 (1+0.15) = $3.352
Constant growth period starts at the end of year 8 and the first dividend of this constant growth
period will be collected in year 9.
D9 = D8(1+g3) = 3.352 (1+0.06) = $3.553
P8 = D9/(r – g3) = 3.553/(0.12 – 0.06) = $59.217
1.5 1.95 2.535 2.915 3.352 + 59 .217
P0 = 4
+ + + + = 0.95 + 1.11 + 1.28 + 1.32 + 25 .27 = $29 .93
1.12 1.12 5 1.12 6 1.12 7 1.12 8
b. D4 = $1.5
D5 = D4(1+g1) = 1.5(1+0.30) = $1.95
D6 = D5(1+g1) = 1.95(1+0.30) = $2.535
D7 = D6(1+g2) = 2.535(1+0.15) = $2.915
D8 = D7(1+g2) = 2.915 (1+0.15) = $3.352
Constant growth period starts at the end of year 8 and the first dividend of this constant growth
period will be collected in year 9.
D9 = D8(1+g3) = 3.352 (1+0.06) = $3.553
P8 = D9/(r – g3) = 3.553/(0.12 – 0.06) = $59.217
2.535 2.915 3.352 + 59 .217
P5 = + + = 2.263 + 2.323 + 44 .535 = $49 .121
1.12 1 1.12 2 1.12 3

2) R=10%

− 39 ,000 440,180 217 ,520 − 2 ,000

a) NPV = −11,000 + + + +
( 1 + .10 ) ( 1 + .10 ) 2
( 1 + .10 ) 3
( 1 + .10 )4

NPV=$479,390.5
Since NPV is positive, accept the project.
− 39 ,000 440,180 217 ,520 − 2 ,000
b) 0 = −11,000 + + + +
( 1 + IRR ) ( 1 + IRR ) 2
( 1 + IRR ) 3
( 1 + IRR )4

If we solve the equation we find that the IRR 408.58%, which is too high and may lead you
incorrectly to the accept answer but be careful the cash flows are nonconventional.

If we draw the NPV profile we see that the profile cuts the x-axis somewhere around 400%
 NPV Profile
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1

c) MIRR discounting approach

Time Cash Flows

0 − 39 ,000 − 2 ,000
− 11,000 + + = −47 ,820.6
( 1 + .10 ) ( 1 + .10 )4

1 0

2 440,180

3 217,520

4 0

440,180 217 ,520

0 = −47 ,820.6 + +
( 1 + MIRR ) 2
( 1 + MIRR )3

If you solve the equation, you find that the MIRR is 225.6%. Because it is above the 10%
required return it is acceptable.

MIRR reinvestment approach

Time Cash Flows

0 -11,000
1 0
2 0
3 0
4 −2,000 − 39,000 × (1.10)3 + 440,180 × (1.10)2 + 217,520 × (1.10) = 717,980.8
 717,980.8
0 = −11,000 +
(1 + 𝑀𝐼𝑅𝑅)4

If you solve the equation, you find that the MIRR is 184.24%. Because it is above the 10%
required return it is acceptable.

MIRR combination approach

Time Cash Flows

0 − 39 ,000 − 2 ,000
− 11,000 + + = −47 ,820.6
( 1 + .10 ) ( 1 + .10 )4

1 0

2 0

3 0

4 440,180* ( 1.10 )2 + 217,520* ( 1.10 ) = 771,889.8

771,889.8
0 = −47 ,820.6 +
( 1 + MIRR )4

If you solve the equation, you find that the MIRR is just above 100.44%. Because it is above
the 10% required return it is acceptable.

d) The results indicate very high IRR and MIRRs but due to the nonconventional cash flows we
should use NPV. In addition in MIRR method, three approaches suggests different rates.

3) Electric-powered vs Gas-powered

Time Gas-powered Electric-powered

0 -$17,500 -$22,000

1 5,000 6,290

2 5,000 6,290

3 5,000 6,290

4 5,000 6,290

5 5,000 6,290

6 5,000 6,290

R=12%
 a) NPV

Gas-powered NPV=-17,500+5,000*PVIFA(12%,6)=3,057

Electric-powered NPV=-22,000+6,290*PVIFA(12%,6)=3,860.71

IRR

Gas-powered =17.98%

Electric-powered=17.99%

b) Because we can only choose one of the machines then it means they are mutually exclusive.
Thus, we should use the NPV method in order to decide. Company should prefer electric-
powered machine since its NPV is higher.

4) Old Machine
Cost of the machine 4 years ago=$600,000
Depreciated to 0 in 6 years
Can be used in the production for another four years
Operating costs=$175,000 per year
Price today=325,000
Price in four years=$50,000

New Machine
Cost of the new machine=$750,000
Depreciatiated to 0 in 4 years
Can be used in the production for another four years
Price in four years=$250,000
Operating costs =$50,000 per year
The inventory will decrease by $5,000 today and $15,000 next year
Last year testing cost= $25,000 (Sunk Cost)
Tax rate=34%
Cost of capital=11%
a)
0 1 2 3 4
Change in Revenues 0 0 0 0
Change in Costs -125,000 -125,000 -125,000 -125,000
Depreciation
New Machine 187,500 187,500 187,500 187,500
Old Machine 100,000 100,000 0 0
Incremental Depr. 87,500 87,500 187,500 187,500
EBIT 37,500 37,500 -62,500 -62,500
Taxes 12,750 12,750 -21,250 -21,250
NI 24,750 24,750 -41,250 -41,250
OCF 112,250 112,250 146,250 146,250
Net Capital Spending -467,500 132,000
Change in NWC 5,000 15,000 -20,000
Total Cash Flows -462,500 127,250 112,250 146,250 258,250

OCF= Net Income + Incremental Depreciation

 Net Capital Spending
Initial Investment (Year 0)
Cost of new machine = – 750,000
Book value of old machine = 600,000 – 4*600,000/6 = $200,000
After tax proceeds from selling the old machine = 325,000 – 0.34*(325,000 – 200,000) = 282,500
Incremental net capital spending = – 750,000 + 282,500 = –467,500 (capital outflow)
Decrease in New Working Capital needs = 5,000
Total Initial Investment = –467,500 + 5,000 = –462,500

Termination CFs (Year 4)

Foregone sale of old machine = – {50000 – 0.34*(50000 – 0)] = – 33000
After tax proceeds from selling the new machine = 250,000 – 0.34*(250,000 – 0) = $165,000
Incremental net capital spending = 165,000 – 33,000 = 132,000 (capital inflow)
Reversal of investment in Net WC over the the life of the project = – [5,000+15,000] = –20,000
Total Termination CFs = 132,000 – 20,000 = 112,000

b) NPV
127 ,250 112,250 146 ,250 258,250
− 462,500 + + + + = 20 ,298.27
( 1.11 ) ( 1.11 ) 2 ( 1.11 )3 ( 1.11 )4
As the NPV is positive, replace the old machine.

5) Pick the least expensive

Time Scion xA Toyota
0 -$15,000 -$20,000
1 -$1,200 -$650
2 -$1,200 -$650
3 -$1,200 -$650
4 -$650

R=12%
a) Net Present Value of Scion xA:
-15,000 + -1,200*PVIFA(12%,3)=-17,882.16
Equal payments annuity for Scion xA
-17,882.16=C*PVIFA(12%,3)
C= -7,445.23
Net Present Value of Toyota
-20000 + -650*PVIFA(12%,4)= -21,974.245
 Equal payments annuity for Toyota
-21,974.245=C*PVIFA(12%,4)
C= -7,234.796

If the machines are replaced forever I look at the equal payments and choose Toyota since its
cost is lower.

Replacement Chain
Time Scion xA Toyota
0 -$15,000 -$20,000
1 -$1,200 -$650
2 -$1,200 -$650
3 -$1,200-$15,000 -$650
4 -$1,200 -$650-$20,000
5 -$1,200 -$650
6 -$1,200-$15,000 -$650
7 -$1,200 -$650
8 -$1,200 -$650-$20,000
9 -$1,200-$15,000 -$650
10 -$1,200 -$650
11 -$1,200 -$650
12 -$1,200 -$650
Net Present Value of Scion xA over 12 years:
NPV = -15,000 + -1,200*PVIFA(12%,12) + -15,000*PVIF(12%,3)
+-15,000*PVIF(12%,6) + -15,000*PVIF(12%,9) = -$46,118.57

Net Present Value of Toyota over 12 years:

NPV = -20000 + -650*PVIFA(12%,12) + -20000*PVIF(12%,4) + -20000*PVIF(12%,8)
= -$44,814.37

If the machines are replaced forever, choose Toyota since it has higher NPV over 12 years.

b) If this is a one time investment I compare their net present values over their original lives and I
still choose Scion xA since it costs less.

6) Cost of the machine=$108,000

Modification cost=$12,500
Total acquisition cost = 108,000+12,500 = $120,500
 MACRS three year class
Salvage value at year 3=$65,000
Increase in inventory=5,500 today
Before tax saving=$44,000 per year
Tax rate= 35%
a)
Years Rate Depreciation expense
1 0.3333 120,500*0.3333 = 40,162.65
2 0.4444 120,500*0.4444 = 53,550.20
3 0.1482 120,500*0.1482 = 17,858.10
4 0.0741 120,500*0.0741 = 8,929.05
Accumulated Depreciation by the end of year 3=40,162.65+53,550.20+17,858.10= $111,570.95
Book Value of the machine at year 3 = 120,500 – 111,570.95 = $8,929.05
After tax proceeds from selling the machine at year 3 = 65,000–0.35(65,000–8,929.05)=45,375.17
0 1 2 3
Revenues 0 0 0
Cost saving -44,000 -44,000 -44,000
Depreciation 40,162.65 53,550.20 17,858.10
EBIT 3,837.35 -9,550.20 26,141.90
Taxes 1,343.07 -3,342.57 9,149.67
Net Income 2,494.28 -6,207.63 16,992.24
OCF 42,656.93 47,342.57 34,850.34
Net capital Spending -120,500 45,375.17
Change in NWC -5,500 5,500
Total CF -126,000 42,656.93 47,342.57 85,725.50
OCF= Net Income + Depreciation

b) R=12%
42,656.93 47 ,342.57 85,725.50
NPV = −126 ,000 + + + = 10 ,845.47
( 1.12 ) ( 1.12 ) 2 ( 1.12 )3
Purchase the machine since its NPV is positive.