Assignment2solutions_Winter2007

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AK/ADMS3530 3.0 Assignment #2 Solutions Winter 2007 Question 1 (18 marks) Blooper Technology Inc. is considering purchasing two machines, A and B, which are expected to generate \$36,000 and \$40,000 respectively in cash flows per year for 5 years. Although Machine B is more expensive than Machine A, its payback period (3.25 years) is shorter compared to that of Machine A (3.5 years). Blooper’s opportunity cost of capital is 10%. (a) Which machine would you take if the machines were mutually exclusive and if shareholder maximization were your basis for decision? Explain. (5 Marks) Answer C OST OF M ACHINE A= 3.50 × 36,000 = \$126,000 C OST OF M ACHINE B= 3.25 × 40,000 = \$130,000 NPV A = -126,000 + 36,000 (PVIFA 5, 10%) = \$10,468.32 NPV B = -130,000 + 40,000 (PVIFA 5, 10%) = \$21,631.47 M ACHINE B SINCE IT HAS A GREATER NPV. (b) If the company is willing to accept any project with a discounted payback period less than 4.25 years, would you recommend buying these machines? Explain. (4 Marks) Answer (C ASH FLOWS IN THOUSANDS OF DOLLARS ) 0 1 2 3 4 5 -126 36 36 36 36 36 \$32.73 \$29.75 \$27.05 \$24.59 \$22.35 D ISCOUNTED PAYBACK A=4.53 YEARS R EJECT BECAUSE DPB > 4.25 0 1 2 3 4 5 -130 40 40 40 40 40 \$36.36 \$33.06 \$30.05 \$27.32 \$24.84

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ADMS3530 3.0 Assignment #2 solutions D ISCOUNTED P AYBACK B= 4.13 YEARS A CCEPT BECAUSE DPB < 4.25 (c) Calculate the internal rate of return on each machine. Would you buy these machines based on IRR? Explain. (3 Marks) Answer IRR OF M ACHINE A: 13.20 % (PV=-126, PMT=36, FV=0, N=5, I=?) IRR OF M ACHINE B: 16.32 % (PV=-130, PMT=40, FV=0, N=5, I=?) Y ES . B OTH IRR S ARE GREATER THAN THE COST OF CAPITAL . (d) Machine A comes with an optional module which extends its useful life 2 more years (with the same annual cash flows of \$36,000) at an additional initial cost of \$20,000. Which machine should you take after considering this option? ( 6 Marks) Answer T HE PV OF THE CF STREAM FROM M ACHINE A = -146 +36 X (PVIFA 7, 10%) = -146 + 36 × 4.8684 = \$29,263.08 E QUIVALENT A NNUAL CF FROM A= \$29,263.08 / 4.8684 = \$6,010.82 T HE PV OF THE CF STREAM FROM M ACHINE B= -130 + 40 × (PVIFA 5, 10%) = -130 + 40 × 3.7908 = \$21,631.47 E QUIVALENT A NNUAL CF FROM B= \$21,631.47 / 3.7908 = \$5,707.31 C HOSE M ACHINE A. Question 2 (10 marks) Calculate the NPV for the following capital budgeting proposal: \$110,000 initial cost, to be depreciated straight-line over five years to an expected salvage value of \$5,000, 35 percent tax rate, \$35,000 additional annual revenues, \$5,000 additional annual expense, \$7,000 additional investment in working capital today to be recovered in year 5. Project has a 9 percent cost of capital. Assume that the CCA is same as depreciation. Page 2
ADMS3530 3.0 Assignment #2 solutions Answer (Cash flows are in dollars) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Cost (110,0 00) Change in Working Capital (7,0 00) 7,0 00 Revenues 35,0 00 35,0 00 35,0 00 35,0 00 35,000 less Expenses 5,0 00 5,0 00 5,0 00 5,0 00 5,000 less Depreciation 21,0 00 21,0 00 21,0 00 21,0 00 21,0 00 = Net Inc. 9,0 00 9,0 00 9,0 00 9,0 00 9,00 0 less Taxes (35%) 3,1 50 3,1 50 3,1 50 3,1 50 3,1 50 = NI After Tax 5,8 50 5,8 50 5,8 50 5,8 50 5,8 50 Salvage Value 5,0 00 Cash Flows (117,0 00) 26,8 50 26,8 50 26,8 50 26,8 50 38,8 50 NPV of Project = PV of Cash Flows - Initial Investment NPV = \$26,850 + - \$117,000 = -\$4,763.68 Given that the NPV is negative, you reject the project.

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