Department of Finance

University of Dhaka
27 Batch, 3rd Year BBA Exam
th

Course; F: 303-Capital Investment Decisions

Sample 1st Midterm Questions

1. MSH Ltd is investigating the feasibility of a new line of power mulching tools aimed at the growing
number of home composters. Based on exploratory conversations with buyer for large garden
shops, MSH projects unit sales as would be 5,000 in the first year and 8,000 in the next 3 year. The
duration of the project would be 4 years.
The MSH Ltd has provided a consultancy fee of $150,000 to MRR Consultancy Ltd which found that
project is feasible. The new power mulcher will sell for $120 per unit to start. When the competition
catches up after three years, however, MSH Ltd anticipates that the price will drop to $110. The
power mulcher project will require $20,000 in net working capital at the start. Subsequently, total
net working capital at the end of each year will be about 15 percent of sales for that year. The
variable cost per unit is $60, and total fixed costs are $25,000 per year. It will cost about $800,000 to
buy the equipment necessary to begin production. This investment is primarily in industrial
equipment, which qualifies as three-year MACRS property (depreciation rate 33.33% 44.45% 14.81%
and 7.41% respectively). The equipment will actually be worth about 20 percent of its cost in eight
years. The relevant tax rate is 34 percent, and the required return is 15 percent. Based on this
information, should MSH Ltd Proceed?
6

Solution

1. Consultancy fee of $150,000 to MRR Consultancy Ltd is a sunk costs and would not affect the project
cash flow. So, we will ignore the sunk cost
2. Applying three-year MACR depreciation rate would produce the following depreciation in each of
next 4 year as follows
MACRS 3 Years Depreciation rate
Year Rate Dep Ending BV
1 33.330% 266,640 533,360.00
2 44.450% 355,600 177,760.00
3 14.810% 118,480 59,280.00
4 7.410% 59,280 -
Each of the depreciation rate is applied on project cost of $800,000. For example, first year depreciation
rate is $800,000*33.33% = 266,640 and ending book value is = 800,000-266,640 = 177,760. Similarly, 2 nd
year depreciation is $800,000*44.450% = 355,600 and second year ending book value is 177,760.

3. OCF : ( Sales – VC- FC- Dep)*(1-tax)+Dep

For example OCF for the 1st year is (5000*120-5000*60-25,000-266,640)*(1-34%) +266,640 = 272,158.

4.
Sale 0 1 2 3 4
600,000.0 960,000.0 960,000.0 880,000.0
NWC -20,000 (90,000.0) (144,000.0) (144,000.0) (132,000.0)
Change in NWC (70,000.0) (54,000.0) - 12,000.0
Recovery of NWC (132,000.0)

In the first year, NWC is 15% of 600,000, sale of first year. The NWC requirement is 90,000. But we
have already invested 20,000 in the year 0. SO net change in NWC is 90,000-20000= 70,000.
In the final year (year 4), we have 15% *88,000 = 132000 requirement. But we have already invested
144,000. So we get back 12,000 as cash inflow from NWC.
Moreover, as the project ends, we will recover all the existing NWC invested till 4 th year which is
132,000. The idea is that as we end project, we will recover cash from ARs, inventory.

5. At the end of the project, we have depreciated the asset fully to zero. But we can sell the asset at
20% of initial cost which is 20%*800,000 =160,000. So profit is sale-cost = 160,0000 –BV at the end
of 4th year which is 0 =160,000. Our cash inflow would be = sale – profit*tax rate = 160,000-
160000*34% =156,000.
 Year 0 1 2 3 4
Units 5,000 8,000 8,000 8,000
Price Per unit 120 120 120 110
VC Per Unit 60 60 60 60

Revenue 600,000.0 960,000.0 960,000.0 880,000.0

VC 300,000.0 480,000.0 480,000.0 480,000.0
FC 25,000.0 25,000.0 25,000.0 25,000.0
Depreciation 266,640.0 355,600.0 118,480.0 59,280.0
EBIT 8,360.0 99,400.0 336,520.0 315,720.0
Tax at 34% 2,842.4 33,796.0 114,416.8 107,344.8
Net Income 5,517.6 65,604.0 222,103.2 208,375.2

OCF 272,158 421,204 340,583 267,655

Initial Invest -800,000

Change in NWC -20,000 -70000 -54000 0 12,000.0
NWC Reovery -132,000

After Tax Salvage Value 105600

Total Project Cash Flow -820,000 202,158 367,204 340,583 253,255

NPV $2,186.66
IRR 15.13%

2. Suppose you are evaluating two different pollution control options. 1 st control system will cost $1.5
million to install and $70,000 annually, before taxes, to operate. This will have salvage value of
100,000 and is expected to be sold at 200, 000 at the end of the life. It will have to be completely
replaced every five years. The system 2 will cost $2 million to install but only $15,000 per year to
operate. This will have salvage value of 300,000 and is expected to be sold at 700, 000 at the end of
the life and has an effective operating life of eight years. Straight-line depreciation is used
throughout. Which option should we select if we use a 12 percent discount rate? The tax rate is 34
percent.
6

Solution

First find the OCF for system 1

OCF = after tax operating cost + Dep Tax shield

After tax operating cost is -70, 0000*(1-.34) = -46,200

Depreciation = (15, 00,000-100,000)/5= 280,000

Depreciation Tax Shield = 280,000*34% =95,200

So OCF = -46,200+95,200=49,000

PV of OCF of 49,000 for next 5 year at 12% rate = 176,634

After tax salvage value = 200,000- (200,000-100,000)*.34 =166,000

PV of after tax salvage value = 66,000/(1.12)5= 94193

Initial investment = -15, 00,000

Total PV of cost = -15, 00,000+94193+ 176,634 =- 12, 29,173

Calculating EAC involves spreading the total PV of total cost over the life of the project equally.

So EAC for system 1 would be

= 12, 29,173* PVAF (12%, 5 year) = 340,985

So EAC for system 1 would be = 311,401 (see the table below)

As system 2 cost less per year, so would select system 2.

System 1 System 2
Operating cost -70,000 -15000
Tax rate 0.34 0.34
After tax operating cost -46200 -9900
Invest 1500000 2000000
Salvage Value 100,000 300,000
Expected sale value 200,000 700,000
Life 5 8
Depreicaiton 280000 162500
Depreciation Tax Shield 95200 55250
OCF 49000 45350
Discount Rate 0.12 0.12
PV of OCF $176,634.03 $225,282.46
After tax salvage value $166,000.00 $564,000.00
Total PV of Cost ($1,229,173.11) ($1,546,927.40)
EAC $340,984.58 $311,400.88
3. Explain the mechanism that help reduce the conflict of interest between the managers and
stockholders and induce managers to the best interest of the shareholders.

Solutions:

Whether managers will, in fact, act in the best interests of stockholders depends on two factors.

First, how closely are management goals aligned with stockholder goals? This question relates, at least
in part, to the way managers are compensated.

Second, can managers be replaced if they do not pursue stockholder goals? This issue relates to control
of the firm.

Managerial Compensation:

Management will frequently have a significant economic incentive to increase share value for two
reasons.

a. First, managerial compensation, particularly at the top, is usually tied to financial

performance in general and often to share value in particular. For example, managers
are frequently given the option to buy stock at a bargain price.

b. The second incentive managers have relates to job prospects. Better performers within
the firm will tend to get promoted. More generally, managers who are successful in
pursuing stockholder goals will be in greater demand in the labor market and command
higher salaries.

Control of the Firm Control of the firm ultimately rests with stockholders. They elect the board of
directors, who, in turn, hire and fire management.

a. An important mechanism by which unhappy stockholders can replace existing

management is called a proxy fight. A proxy is the authority to vote someone else’s
stock. A proxy fight develops when a group solicits proxies in order to replace the
existing board and thereby replace existing management.

b. Another way that management can be replaced is by takeover. Firms that are poorly
managed are more attractive as acquisitions than well-managed firms because a greater
profit potential exists. Avoiding a takeover by another firm gives management another
incentive to act in the stockholders’ interests.