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Capital Budgeting Solutions7

Capital Budgeting Solutions7 - The companys overall WACC is...

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Old Exam Questions - Capital Budgeting - Solutions Page 61 of 96 Pages The company’s overall WACC is 10 percent. However, the proposed project is riskier than the average project and the project’s WACC is estimated to be 12 percent. The company’s tax rate is 40 percent. Given this information, determine the net present value of the proposed project. (You may wish to use the table below to help organize the data.) Cash Flow Item Year 0 Year 1 Year 2 Year 3 Year 4 Sales $2,000,000.00 $3,000,000.00 $3,000,000.00 $2,000,000.00 Operating Costs -$1,000,000.00 -$1,500,000.00 -$1,500,000.00 -$1,000,000.00 Depreciation -$500,000.00 -$500,000.00 -$500,000.00 -$500,000.00 EBIT Taxes NOPAT Depreciation OCF Investment -$2,000,000.00 NOWC -$100,000.00 $100,000.00 Cannibalization Free Cash Flow PV NPV A. $88,648.74 B. $82,274.45 * C. $86,786.19 D. $80,593.36 E. $84,437.97 Cash Flow Item Year 0 Year 1 Year 2 Year 3 Year 4 Sales $2,000,000.00 $3,000,000.00 $3,000,000.00 $2,000,000.00 Operating Costs -$1,000,000.00 -$1,500,000.00 -$1,500,000.00 -$1,000,000.00 Depreciation -$500,000.00 -$500,000.00 -$500,000.00 -$500,000.00 EBIT $500,000.00 $1,000,000.00 $1,000,000.00 $500,000.00 Taxes -$200,000.00 -$400,000.00 -$400,000.00 -$200,000.00 NOPAT $300,000.00 $600,000.00 $600,000.00 $300,000.00 Depreciation $500,000.00 $500,000.00 $500,000.00 $500,000.00 OCF $800,000.00 $1,100,000.00 $1,100,000.00 $800,000.00 Investment -$2,000,000.00 NOWC -$100,000.00 $100,000.00 Cannibalization -$250,000.00 -$250,000.00 -$250,000.00 -$250,000.00 Free Cash Flow -$2,100,000.00 $550,000.00 $850,000.00 $850,000.00 $650,000.00 PV -$2,100,000.00 $491,071.43 $677,614.80 $605,013.21 $413,086.75 NPV $86,786.19 Note that interest expense is not included, since finance charges are handled through the use of WACC. CFj = -2,100,000 CFj = 550,000
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Old Exam Questions - Capital Budgeting - Solutions Page 62 of 96 Pages CFj = 850,000 CFj = 850,000 CFj = 650,000 I/YR = 12% Solve for NPV = $86,786.19 60. Assume that your company is considering a project that has an up-front cost of $1,500,000 at Year 0. The project’s subsequent cash flows are uncertain: there is a 75 percent chance that the cash flows will be $500,000 at the end of each of the next seven years (Years 1-7), and a 25 percent chance that the cash flows will be $50,000 at the end of each of the next seven years (Years 1-7). (Hint: this gives an expected cash flow of $387,500 per year and an NPV of $386,512.29 at a discount rate of 10 percent.) If your company waits one year to take on this project, it would know with certainty whether the cash flows will be $500,000 or $50,000 (in which case it might not take on the project). If it waits a year, the project’s up-front cost will increase to $1,600,000 at Year 1 and the subsequent cash flows ($500,000 or $50,000) will be received only for six years (Years 2-7). Now assume that all cash flows should be discounted at 10 percent. Determine how much waiting a year will increase or decrease the project’s expected NPV in today’s dollars (that is, at Year 0), relative to the project’s NPV if it proceeds today. * A. $7,326.59 B. $6,974.48 C. $8,688.76 D. $7,803.27 E. $8,217.62 First, find the value of the project if it is taken on today: Expected cash flow = ($500,000)(.75) + ($50,000)(.25) = $387,500 CFj = -1,500,000 CFj = 387,500 Nj = 7 I/YR = 10% Solve for NPV = $386,512.29 Alternatively, N = 7; I/YR = 10; PMT = -387,500, Solve for PV = 1,886,512.29 NPV = $1,886,512.29 - $1,500,000.00 = $386,512.29 _______________ Find NPV at Year 1 if firm takes on project and cash flow is $500,000
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Old Exam Questions - Capital Budgeting - Solutions Page 63 of 96 Pages CFj = -1,600,000 CFj = 500,000 Nj = 6 I/YR = 10% Solve for NPV = $577,630.35 __________ Find NPV at Year 1 if firm takes on project and cash flow is $50,000 CFj = -1,600,000 CFj = 50,000 Nj = 6 I/YR = 10% Solve for NPV = -$1,382,236.97 _______________ Therefore, the firm will not take on the project at Year 1 if they know the cash flow will be $50,000. The expected value at Year 0 of delaying the start of the project until Year 1 is: [($577,630.75)(.75) + ($0.00)(.25)] / [1.10] = $393,838.88 Therefore, the increase in NPV is: $393,838.88 - $386,512.29 = $7,326.59
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