Problem Set – 6

Chapter 11

1. The initial purchase of the equipment costs $60,000 with a straight line depreciation

of $15,000 over four years. Depreciation per year of the equipment is calculated by

dividing its initial cost by the number of years. Calculating the cash flows at a tax rate

of 25% for 6 years of the project with a depreciation of $23,000 each year, we have –

Year 1 2 3 4 5 6
Cash flow before interest
and depreciation $23 $23 $23 $23 $23 $23
Depreciation $15 $15 $15 $15 - -
EBT $8 $8 $8 $8 $23 $23
Taxes (25%) $2 $2 $2 $2 $6 $6
EAT $6 $6 $6 $6 $17 $17
Adding Depreciation $15 $15 $15 $15 - -
Cash flow $21 $21 $21 $21 $17 $17

Note that there is also an initial outflow of cash used to buy the equipment for

$60,000. The cash flow is calculated in ($1000’s). Also note that the difference in the

cashflow for the first 4 years is only because of the depreciation of the newly

purchased equipment which has a life of 4 years.

2. The initial cash outflow will be the cost of the new mixer which is $90,000 and will

only be reflected in year 0. Further, this new purchase of the equipment saves $40,000

each year for the next 5 years which can be considered as cash inflow. The mixer’s

depreciation will be a straight line depreciation for three years which brings the cost

of depreciation about $30,000 each year.

Year 0 1 2 3 4 5
Cost $ 90 $ - $ - $ - $ - $ -
Savings $ - $ 40 $ 40 $ 40 $ 40 $ 40
Depreciation $ - $ 30 $ 30 $ 30 $ - $ -
EBT impact $ - $ 10 $ 10 $ 10 $ 40 $ 40
 $ $ $
Tax $ - 3 3 3 $ 12 $ 12
$ $ $
EAT $ - 7 7 7 $ 28 $ 28
Adding Depreciation $ - $ 30 $ 30 $ 30 $ - $ -
Sales $ - $ - $ - $ - $ - $ 20
Taxes on Sales $ - $ - $ - $ - $ - $ -6
Cash flow $ -90 $ 37 $ 37 $ 37 $ 28 $ 42

Again, the difference in cash flows is impacted by the limited depreciation of the new

mixer and the savings accumulated over 5 years by purchase of the new equipment.

3. There is an initial outflow of cash for the purchase of new equipment which will cost

the company around $150,000. The company is looking to sell their old equipment for

$75,000 which has a book value of $35,000 and will generate a profit of $40,000

which is reflected on the cashflow statement. So after considering everything, we

have the following statement –

Sale of old equipment $ 75,000   $ 75,000

Book value $ 35,000  
Accounting profit $ 40,000  
Tax on profit $ -14,000 $ -14,000
Cash flow from sale $ 61,000
   
Cost of new equipment $ 1,50,000
Cash from sale $ -61,000
Initial outflow     $ 89,000

So as per calculations, the initial outflow of cash which was used to buy the

equipment worth $150,000 will cost the company $89,000 after selling their old

equipment at a price of $75,000. This is a very good deal and the company should go

ahead with it.

4. The initial outflow of cash will be the purchase of equipment which is $100,000 plus

the hiring and training costs of the employees which will be $120,000 in total keeping

in mind that each employee costs the company $12,000 each and there will be a total

of 10 employees. The selling price of the old machinery is $36,000 which has value
 on the books as $22,000, and a profit of $14,000 will be made after selling the old

machinery. The cash flow statement is as follows considering a tax rate of 40%-

Cost of hiring and training $ 1,20,000    

Tax saving (40%) $ 48,000  
Net cash flow after tax $ 72,000  
   
Sale of old equipment $ 36,000 $ 36,000
Book value $ 22,000  
Accounting profit $ 14,000  
Tax on profit $ 5,600 $ -5,600
Cash flow from sale $ 30,400
   
Cost of new equipment $ 1,00,000
After tax cost of hiring and training $ 72,000
Cash from sale $ -30,400
Initial outflow     $ 1,41,600

So to start the project, the company will need at least $141,600 after selling the old

equipment at a price of $36,000 considering the hiring and training cost on 10 new

employees needed for the project.

Chapter 12

1. The company will produce an initial cash outflow of $5M for the project and is

expected to receive two cash inflows during the project at the end of year 1 and year

2. There are two scenarios for the company in which the NPV of the project will

differ. The best case scenario is that the company receives a cash inflow $3M for the

first year and $4M for the second year whereas if the project isn’t as successful, there

will be cash inflows of $1M and $2.5M respectively. The basic formula for

calculating the NPV of the project is as follows where the cash inflows will be

substituted for each scenario at cost of capital 12% –

NPV = -C0 + C1 [PVF12,1] + C2 [PVF12,2]

The best case scenario where C1 = $3M and C2 = $4M

 NPV = -$5M + $3M (0.8929) + $5M (0.7972)

NPV = -$5,000,000 + $2,678,700 + $3,188,800

NPV = $867,500

The worst case scenario where C1 = $1M and C2 = $2.5M

NPV = -$5,000 + $1M (0.8929) + $2.5M (0.7972)

NPV = -$5,000 + $892,900 + $1,993,000

NPV = -$2,114,100

The NPV ranges from -$2,114,100 to $867,500. If the worst case scenario happens,

the NPV becomes negative and the company will bear losses whereas in the best case

scenario, there is a positive NPV but not as much as the negative NPV in the worst

case scenario. This means that the project is risky as the company will bear more

losses than profit if the worst case scenario is to happen.

10. The project will have an additional path which is if the project is abandoned and will

generate an additional $5 million in the 2nd year. There is a 14% cost of capital. To

figure out the ability of the project abandonment, we need to create a project path with

the probabilities which is as follows-

 Path 3 represents the path if the project is abandoned. Calculating the probability and

NPV, we have –

NPV = 6,000 + 2000 [PVF14,1] + 5000 [PVF14,2]

NPV = 6,000 + 2,000 (0.8722) + 5,000 (0.7695)

NPV = 6,000 + 1,754.4 + 3,847.5

NPV = 398.1 with probability of 0.40

The expected NPV of the project would be the sum of all the 3 paths NPV’s

combined, which gives us –

Expected NPV = 2895.3 (.18) + 1356.3 (.42) - 398.1 (.4)

Expected NPV = 521.2 + 569.6 – 159.2

Expected NPV = 931.6

Compared to when we do not have the possibility of abandoning the project to this

calculation, we can establish that the project’s expected NPV is higher when there is a

possibility of abandoning the project. The NPV has increased by $652.6. By having

an option to abandon the project, the risk factor has reduced as most of the initial

investment amount would be returned and this seems to be the better option.

13. The initial outflow of cash was $1,400 and undertaking the option put forth by Viola

would recover 70% of that initial investment which is-

$1,400 * 0.70 = $980

The decision path now looks like this –

Calculating the NPV and probabilities for each path, we have

Path 1

NPV = -1550 + 1680 [PVF10,1]

NPV = -1550 + 1680(.9091)

NPV = -1550 + 1527.29

NPV = -22.71

With probability of 0.6

Path 2

NPV = -1550 + 900 [PVF10,1] + 1500 [PVF10.2]

NPV = -1550 + 900(.9091) + 1500(.8264)

NPV = -1550 + 818.19 + 1239.60

NPV = 507.79

With probability of 0.4*0.4 = 0.16

Path 3

NPV = -1550 + 818.19 + 1200 [PVF10.2]

NPV = -1550 + 818.19 + 1200(.8264)

NPV = -1550 + 818.19 + 991.68

NPV = 259.87

With probability of 0.4*0.6 = 0.24

The total expected NPV is given by combining all the three calculated NPV’s

Expected NPV = -22.71(0.6) + 507.79(0.16) + 259.87(0.24)

Expected NPV = -13.63 + 81.25 + 62.37

Expected NPV = 129.99

So, the value of the real option is now the difference between this expected NPV and

the NPV of the project calculated originally when the offer by Viola wasn’t proposed.
 Value of real option = $129.99 - $122.58 = $7.71

This proves that the offer proposed by Viola is actually beneficial even after paying

the advance on the proposal. Although, the difference is not big but it is still the better

option.

16. The initial outflow of the cash for the project would be $10M with regular cash

inflows of $1.7M annually for the next 8 years. The stock earns 8% and return on

treasury bills is 4% with the beta of the share at 0.5 whereas the competitor’s share

has a beta of 1.5. Calculating the discount rate of the project comparing it with the

competitor’s beta, we get

kx = krf + (kM – kRF)bx

kx = 4+ (8 – 4) 1.5

kx = 10%

Using this discount rate, we calculate the NPV of the project through excel with

period of 8 years, annual payments of $1.7M and initial investment of $10M which

gives us the NPV of – 0.93062 which is negative. The negative NPV indicates that the

project will not be successful if they enter the market as the competitor’s beta is much

higher. The project would probably see success if there was no other competitor.