Problem Set II - Risk Return and Capital Budgeting

# Problem Set II - Risk Return and Capital Budgeting -...

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Problem Set II Risk Return and Capital Budgeting This assignment is for practice only. It will not be graded and does not have to be turned in. For simplicity, assume that all operating cash flows occur at year-end. Assume that the tax rate for capital gain/loss is the marginal tax rate. 1. ( Equivalent Annual Cost ) Darwin Milk Company must replace a faulty machine with a new machine that it expects to use over the next six years. The company can buy either Machine A (useful life of 6 years, costs \$1 million, and generates annual incremental cash flow after taxes, CFAT, of \$250,000) or Machine B (useful life of only 3 years, costs \$400,000 and generating annual incremental CFAT of \$200,000). Which machine should the company buy if a. Machine B can be replaced at the same cost after 3 years and will generate the same incremental CFAT as before? b. Machine B can be replaced at \$550,000 after 3 years but will generate the same incremental CFAT as before? Assume that the appropriate discount rate for both machines is 10%. 2. ( Option to Delay ) Wisconsin Sprinkler System (WSS) has bid on a major contract to provide fire protection to an office building. The company will learn whether it has been awarded the contract one year from today. Kirk Tuscon, the manager, estimates that there is a 70% probability of WSS getting the contract. In anticipation of getting the contract, WSS must commit now to purchase the equipment necessary to perform the work. The cost of the equipment is \$1,000,000, and it will be purchased in one year. If the firm is awarded the contract, it will receive \$250,000 per year for ten years, with the first cash flow occurring one year after the contract is received . The risk-adjusted required rate of return on the project is 15%. If the contract is awarded to another company, WSS will still have to purchase the equipment in one year, but will have no use for the equipment.

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## This note was uploaded on 01/15/2010 for the course FIN 357 taught by Professor Hadaway during the Fall '06 term at University of Texas at Austin.

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Problem Set II - Risk Return and Capital Budgeting -...

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