Assignment2solutions_Winter2007

Assignment2solutions_Winter2007 - AK/ADMS3530 3.0...

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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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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
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This note was uploaded on 12/14/2011 for the course FINANCE 3530 taught by Professor Delta during the Spring '11 term at York University.

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Assignment2solutions_Winter2007 - AK/ADMS3530 3.0...

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