You asked:
"Part 1
The ACME Company is evaluating a capital expenditure proposal that requires an initial
investment of $1,040,000. The machine will improve productivity and thereby increases
net after-tax cash inflows by $250,000 per year for 7 years. It will have no salvage
value. The company requires a minimum rate of return of 12 percent on this type of
capital investment.
Determine the net present value (NPV) of the investment proposal. (The PV annuity
factor for 12%, 7 years is 4.564.)
Determine the proposal's internal rate of return, rounded to the nearest tenth of a
percent. (Note: PV annuity factors for 7 years: @ 10% = 4.868; @ 11% = 4.712; @ 12%
= 4.564; @ 13% = 4.423; @ 14% = 4.288; @ 15% = 4.160; and, @ 20% = 3.605.)
What is the estimated payback period for the proposed investment, under the
assumption that cash inflows occur evenly throughout the year?
What is the present value payback period for the proposed investment?
What is the estimated accounting rate of return (on initial investment) for the proposed
project?
Part 2
Miller Inc. is considering replacing an old drilling machine that cost $200,000 six years
ago with a new one that costs $450,000. Shipping and installation cost an additional
$60,000. The old machine has been depreciated using straight-line method with no
salvage value over an estimated 8-year useful life. The old machine can be sold for
$40,000 now or $10,000 in two years. Management expects increases in inventories of
$10,000, accounts receivable of $32,000, and accounts payable of $12,000 if the new
machine is acquired. Miller's income tax rate is expected to be 30 percent over the
years affected by the investment.
What is Miller's net initial investment (i.e., its after-tax initial cash outlay for the
machine)?
Part 3
Adams Company is evaluating a new tractor that costs $1,350,000 to replace the tractor
purchased years earlier, which currently has no salvage value; the new tractor has an
estimated useful life of five years with no disposal value or anticipated cost of disposal.
The company uses straight-line depreciation with no residual value on all equipment.
Adams is subject to a 40% income tax rate. The company uses a 12% hurdle rate for
evaluating capital investment projects. The PV of an annuity of $1 at 12% for 5 years is
3.605, and the PV of $1 at 12% in 5 years is 0.567.
Compute the amount of before-tax savings that must be generated by the new tractor to
have a payback period of no more than 3 years.
Compute the amount of before-tax savings that must be generated by the new tractor to
have a NPV of at least $500,000 at a desired rate of return of 12%.
Compute the amount of before-tax savings that must be generated by the new tractor to
have an IRR of 12%.
Part 4
ABC Construction, Inc. is currently considering developing, on a piece of land currently
held by the company, a new courtyard motel. This project would provide a single payoff
from a buyer in one year (after construction was completed). The concept of a courtyard
motel is relatively new, so there is a certain amount of risk associated with this project.
The company's management feels that new information regarding potential consumer
demand would be revealed, that is, whether in the chosen geographic location a
courtyard motel would be popular ("good news") or unpopular ("bad news"). In the
former case, you anticipate a selling price of $13 million, while in the latter case only $9
million. At the present, these two outcomes are considered equally likely. For projects of
this sort, the company uses a WACC (discount rate) of 10% after tax. The company
estimates that total construction costs for this project would, in today's dollars, be
approximately $9.7 million.
Based on the given probabilities for the two possible outcomes (states of nature), what
is the expected NPV of the proposed investment?
What is the primary deficiency of the traditional DCF analysis you conducted above in
(1)?
Suppose now that management has an option to wait a year before deciding whether to
construct the motel in question. The question the company is grappling with is whether it
should delay the investment decision for one year. Given the information above, what
do you recommend, and why? (For simplicity, assume that one year from now the
investment cost would be $9.7 million and that the return one year later would be $13
million.)
Part 5
AMCE Company is considering two mutually exclusive investment alternatives. Its
estimated weighted-average cost of capital, used as the discount rate for capital
budgeting purposes, is 10%. Following is information regarding each of the two projects:
Alternative 1 Alternative 2
Required investment outlay $170,000 $100,000
Incremental after-tax cash inflows/year $50,000 $30,000
Estimated project life (in years) 5 5
Estimated salvage value (end of life) $0 $0
Compute the estimated net present value of each project and determine which
alternative, based on NPV, is more desirable. (The PV annuity factor for 10%, 5 years,
is 3.7908.)
Compute the profitability index (PI) for each alternative and state which alternative,
based on PI, is more desirable.
Why do the project rankings differ under the two methods of analysis? Which alternative
would you recommend, and why?
"
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