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**Unformatted text preview: **Finance 100: Problem Set 5 1. Consider the following capital budgeting problem. The following two ma- chines are mutually exclusive and the firm would keep reinvesting in what- ever machine it buys. Machine A would be reinvested every 4 years, machine B every 3 years. The cash flows associated with each machine are tabulated as follows; all numbers are in thousand dollars; the relevant discount rate is 10% for both machines. Year Machine A Machine B-80-100 1 50 60 2 50 60 3 50 60 4 25- 1.a Which of the two machines is the better investment project? Analyze the question under the assumption that whatever machine the company buys has to be reinvested in perpetuity. 1.b Suppose A fits current technology, whereas machine B needs a one-time re- tooling for the company. These one-off installation costs would be $10,000 today. What is the optimal investment decision now? 1 1.c Suppose the firm has an old machine in place that would serve for another two years. They can postpone investing in either machine A or B and keep using this machine. When should they stop using the old machine? Cash flows for the old machine are: Year Cashflow 1 50 2 20 3 1.d Suppose the investment opportunity described above lasts only for 24 years. Recalculate your decision rule for questions 1.a and 1.b . What is the NPV of the optimal investment policy now? 2. A corporation is considering purchasing a machine that has an expected eight-year life and will generate for the firm $11,000 per year in net operating income before taxes. The machine will be depreciated using the straight-line method to its anticipated salvage value of $12,000. The firm has a 34% marginal tax rate and the required return for this project is 12% p.a. If the machine costs $60,000, should it be purchased? 3. Another machine salesman comes by the company’s office and says that he is willing to negotiate the purchase price of the machine described in the previous question. What is the maximum price the firm is willing to pay for the machine? [Hint: the price of the machine determines the level of depreciation and therefore the taxes that the firm pays]. 4. A corporation is considering purchasing a machine that has an 8-year life and will save the firm $4,500 per year in net operating costs. The machine would be depreciated on a straight-line basis to a zero salvage value. The firm has a 34% tax rate and a 12% p.a. required rate of return on this project....

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