Economics 173 – Corporate Finance
Winter 2006-07
Prof. Garey Ramey
Problem Set 2
Problem 2.1.
Calculate the cost in PV terms of the following equipment purchases. In
each case assume the tax rate is 35%.
a.
Original cost of $125,000, depreciated straight-line to an ending book value of
$25,000 at the end of year 5, scrapped at the end of year 5, zero scrap value.
Projected inflation rate is zero, OCC is 12%.
b.
Original cost of $2 million, depreciated using the five-year tax depreciation schedule
(p. 128 of textbook) to an ending book value of zero, scrapped for $250,000 at the
end of year 8.
Projected inflation rate is zero, OCC is 7%.
c.
Original cost of $750,000, depreciated straight-line to an ending book value of
$150,000 at the end of year 3, scrapped for $60,000 at the end of year 5, scrap price
expressed in today’s dollars.
Projected inflation rate is 4%, OCC is 13%.
Problem 2.2.
Snootjoy Wines is considering the purchase of an automatic winepress for
$160,000.
The press will be operated for six years, after which it will be scrapped.
At
the end of year 6 a scrap value of $20,000 will be received.
Further, a major overhaul of
the winepress will be required at the end of year 3, at a cost of $10,000.
For tax purposes, 20% of the initial investment may be depreciated in each year for
years 1 through 4, and 10% in years 5 and 6.
The overhaul costs may be treated as a
current expense.
The tax rate is 35% and the OCC is 9%.
What is the net cost of this
equipment in PV terms?
Problem 2.3.
Sunset Properties, Inc., is considering investing $250 million in land that it
will hold for 25 years and then resell.
The investment generates pretax net cash flows of
$40 million per year, expressed in today’s prices. Land prices are expected to rise at the
rate of 7% per year.
The OCC is 13%, the projected inflation rate is 2%, and the tax rate
is 45%.
What is the NPV of this investment?
Problem 2.4.