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case2_03_2

# case2_03_2 - Capital budgeting with staged entry Financial...

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Capital budgeting with staged entry Financial management and policy Case 2, week 3 University of Maastricht Faculty of Economics and Business Administration Maastricht, 12 th of November 2003 Danner, W. I 136964 Kuijt, R.J. I 130885 Steenvoorden, W.J.M. I 178829 Course Code: 6010v Group number: 7 Subgroup number: 1 Tutor: B. Pavlov

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1) a) What cost, if any should be attributed to the trout project, concerning land acquisition? The costs that should be attributed to the trout project amounts \$ 1500000, because suitable sites can be purchased for this amount. The option doesn’t have to be taken into account, since it concerns an option Gulf Coast Fisheries, INC inc. has to acquire additional land for the Salmon Division. If the land is used for the trout project, Salmon Division should purchase a new site by exercising the option. The option (paying \$ 100000 in December 1995 and \$ 1.900.000 in December 1999) is more valuable than buying land today for a price of \$ 1500000. This can be examined in the following calculation: b) What discount rate should be used in analyzing the option alternative? \$ 1500000 * 1,09 4 = \$ 2117372.4(9% is the annual appreciation of land) \$ 2117372.4 - \$ 1.900.000 / (1,04) 4 = \$ 185810.8 (Opt. val. – init. Inv. disc. by the an. infl. rate) \$ 185810.8 - \$ 100.000 = \$ 85810.8 (Option gain - option price = option value) By exercising the option, the Salmon Division would obtain a profit of \$ 85810.8, compared to buying land for \$ 1.500.000 today. Additional to this, with the option the Salmon Division can decide whether or not to continue the project, depending on development of market circumstances. The discount rate used in the calculation is the inflation rate, which was assumed to be the risk free rate. 2) a) What would be the R&D cash flows be in 1998 through 2000. Should the R&D cash flow for 1996 be included in the calculations as well? The R&D cash flows that should be taken into account for the years 1998 to 2000 are \$ 600000. This amount is amortized over three years and therefore the annual amortization expense for R&D amounts to \$ 200.000. The initial R&D cash was \$ 1000000 in 1995, of which \$ 400000 was expensed immediately for tax purposes. Therefore these \$ 400000 are not considered in the years of analysis. b) How is salvage value taxed? According to the 31.5-depreciation method, the market value for the building under Plan L amounts \$ 2336525 after seven years. With respect to the building under Plan S, a market value of \$ 5104842 can be calculated over the same period of time, including the building expansion after the third year. Given that the salvage value is half of the buildings book value, 2
this means that a gain would arise from selling the building under plan L being \$ 663475 and a loss would arise from selling the building under plan S of \$ 2104842. Taxation of salvage value is dependent on prescribed tax regulation. Whether the occurred loss therefore decreases taxable income cannot be determined with certainty. When the building under Plan L or S is sold for half of the book value, respectively \$ 1.5 or \$ 1.8 million, taxes have to be paid of \$ 600.000 or \$ 720.000. However, when the building would be sold for their true market values, taxes of \$ 955.672 or \$ 1.225.162 have to be paid.

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