173LecExW07

# 173LecExW07 - Economics 173 Corporate Finance Prof Garey...

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Economics 173 – Corporate Finance Winter 2006-07 Prof. Garey Ramey Lecture Examples - Revised 1. Present Value Analysis Example 1.1.a. (PQ 2.2, p. 31) A parcel of land costs \$500,000. For an additional \$800,000 you can build a motel on the property. The land and property should be worth \$1,500,000 next year. Suppose that common stocks with the same risk as this investment offer a 10 percent expected return. Would you construct the motel? Why or why not? b. Suppose that real estate investments are substantially riskier than common stocks. The expected return on real estate investments is 17 percent. Is the motel still worth constructing? c. Suppose the motel takes an additional year to complete. Let the expected annual return for real estate investments be 10 percent, whether they are held one year or two years. Is the motel still worth constructing? Example 1.2.a. (PQ 3.6, p. 53) A factory costs \$400,000. It will produce an inflow after operating cost of \$100,000 in year 1, \$200,000 in year 2, and \$300,000 in year 3. The opportunity cost of capital is 12 percent. Calculate the NPV. b. Suppose the cash flows from the factory are delayed by two years. Example 1.3.a. (PQ 3.4, p. 53) A factory costs \$800,000. You reckon that it will produce an inflow after operating costs of \$170,000 a year for 10 years. If the opportunity cost of capital is 14 percent, what is the net present value of the factory? b. Suppose the cash flows from the factory are delayed by three years. What is the NPV in this case? c. What will the factory be worth at the end of five years? d. Suppose cash flows from the factory are received semiannually, starting six months from now. What is the NPV in this case? e. Suppose cash flows from the factory are received in a continuous stream. What is the NPV in this case? Example 1.4. (PQ 3.8, p. 53) As the winner of a breakfast cereal competition, you can choose one of the following prizes: a. \$100,000 now. b. \$180,000 at the end of five years. c. \$11,400 a year forever. d. \$19,000 for each of 10 years. e. \$6,500 next year, and increasing thereafter by 5 percent a year forever. If the interest rate is 12 percent, which is the most valuable prize? Example 1.5. A new product requires an up front investment of \$650,000. Starting at the end of the year, the product will generate cash flows of \$150,000 per year for eight

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2 years. After that, cash flows will continue for 10 more years, declining at a rate of 12 percent per year. The OCC is 16 percent. 2. Evaluating Investment Projects Example 2.1.a. Your company is purchasing a new piece of equipment for \$35,000. For accounting purposes, the equipment will be depreciated straight-line for three years to an ending book value of \$5,000. The equipment will be sold for scrap at the end of year four, with scrap value of \$8,000. Your company’s tax rate is 35 percent, and it applies a discount rate of 12 percent to all future cash flows. What is the net cost of the equipment in PV terms? b.
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173LecExW07 - Economics 173 Corporate Finance Prof Garey...

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