MBA570 Homework 3. Instructions: Either type or write your answers directly on this document and submit the completed assignment to your ESO. Show your work for the calculations. If you use additional documents for the calculations, label them with your name and course number (MBA 570) and submit them as well. Each question is worth 10 points.
1. You have been offered a very long-term investment opportunity. You can invest $1,100 today and expect to receive $128,000 in 40 years. Your cost of capital for this (very risky) opportunity is 16%.
a. The IRR of this investment opportunity is __________ %. (Round to one decimal place.)
The IRR rule says that you __________. (Select the best answer.)
A. should not invest
B. should be indifferent
C. should invest
b. The NPV of this investment opportunity is __________ %. (Round to the nearest cent.)
The NPV rule says that you __________. (Select the best answer.)
A. should not invest
B. should be indifferent
C. should invest
2. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The sign will cost $10,000 and will be posted for one year. You expect that it will generate additional revenue of $1,900 a month. The payback period is __________ months. (Round to two decimal places.)
3. You are considering making a movie. The movie is expected to cost $10.5 million upfront and take a year to make $4.9 million in the year it is released (end of year 2) and $1.7 million for the following four years (end of years 3 through 6).
a. The payback period of this investment is __________ years. (Round up to nearest integer.)
b. If you require a payback period of two years, would you make this movie?(Enter yes or no.)
c. If the cost of capital is 10.3%, the NPV is $__________ million.(Round to two decimal places.)
4. AOL is considering two proposals to overhaul its network infrastructure. They have two bids. The first bid from Huawei will require a $15 million upfront investment and will generate $20 million in savings for AOL each year for the next three years. The second bid from Cisco requires an $81 million upfront investment and will generate $60 million in savings each year for the next three years.
a. What is the IRR for AOL associated with each bid?
The IRR associated with the bid from Huawei is __________ %. (Round to one decimal place.)
The IRR associated with the bid from Cisco is __________ %. (Round to one decimal place.)
b. If the cost of capital for this investment is 14%, what is the NPV for each bid?
The NPVfor Huawei’s bid is $__________ million. (Round to two decimal places.)
The NPVforCisco’s bid is $__________ million. (Round to two decimal places.)
c. Suppose Cisco modifies its bid by offering a lease contract instead. Under the terms of the lease, AOL will pay $26 million upfront, and $35 million per year for the next three years. AOL’s savings will be the same as with Cisco’s original bid.
The IRR of the Cisco bid is now __________%. (Round to one decimal place.)
The new NPV is $__________ million. (Round to two decimal places.)
d. AOL should:
A. choose Huawei.
B. choose Cisco without lease.
C. choose Cisco with lease.
D. take none of the bids.
5. Natasha’s Flowers, a local florist, purchases fresh flowers each day at the local flower market. The buyer has a budget of $1,000 per day to spend. Different flowers have different profit margins, and also a maximum amount the shop can sell. Based on past experience the shop has estimated the following NPV for purchasing each type:
NPV per bunch | Cost per bunch | Max. bunches | |
Roses | $2 | $20 | 25 |
Lilies | $10 | $29 | 10 |
Pansies | $6 | $30 | 10 |
Orchids | $21 | $80 | 5 |
(Select based on descending order of their profitability-index values. Round the investment amounts to the nearest integer.)
The combination of flowers Natasha’s Flowers should purchase each day is(select one of the three for each):
$__________ of (roses, pansies, lilies) Select one of the three.
$__________ of (orchids, pansies, lilies) Select one of the three.
$__________ of (lilies, orchids, pansies) Select one of the three.
6. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $21 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 46% will come from customers who switch to the new, healthier pizza instead of buying the original version.
a. Assuming customers will spend the same amount on either version, the incremental sales associated with introducing the new pizza are $__________ million. (Round to the nearest integer.)
b. Suppose that 59% of the customers who will switch from Pisa Pizza’s original to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. In this case, the incremental sales associated with introducing the new pizza are $__________ million. (Round to the nearest integer.)
7. Cellular Access Inc. is a cellular telephone service provider that reported net operating profit after tax (NOPAT) of $259 million for the most recent fiscal year. The firm had depreciation expenses of $128 million, capital expenditures of $152 million, and no interest expenses. Working capital increased by $12 million. The free cash flow for Cellular Access for the most recent fiscal year is $__________ million.(Round to the nearest million.)
8. Castle View Games would like to invest in a division to develop software for video games. To evaluate this decision, the firm first attempts to project the working capital needs for its operation. Its chief financial officer has developed the following estimates (in millions of dollars):
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash | 7 | 12 | 14 | 15 | 16 |
Accounts receivable | 18 | 22 | 23 | 22 | 25 |
Inventory | 4 | 9 | 10 | 12 | 16 |
Accounts payable | 16 | 19 | 25 | 28 | 32 |
Assuming that Castle View currently does not have any working capital invested in this division, calculate the cash flows associated with the changes in working capital for the first five years of this investment. (Note: Enter decreases as negative numbers.)
a. The change in working capital for year 1 is $__________ million.(Round to the nearest million.)
b. The change in working capital for year 2 is $__________ million. (Round to the nearest million.)
c. The change in working capital for year 3 is $__________ million. (Round to the nearest million.)
d. The change in working capital for year 4 is $__________ million. (Round to the nearest million.)
e. The change in working capital for year 5 is $__________ million. (Round to the nearest million
9. Markov Manufacturing recently spent $12 million to purchase some equipment used in the manufacturing of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 39%. The company plans to use straight-line depreciation.
a. The annual depreciation expense associated with this equipment is $__________ million. (Round to two decimal places.)
b. The annual depreciation tax shield is $__________ million.(Round to two decimal places.)
c. Rather than straight-line depreciation, suppose Markov will use the MACRS depreciation for five-year property. Calculate the depreciation tax shield each year for this equipment under the following accelerated depreciation schedule:
MACRS Depreciation Table | |
Year | 5 Years |
1 | 20.00% |
2 | 32.00% |
3 | 19.20% |
4 | 11.52% |
5 | 11.52% |
6 | 5.76% |
The depreciation tax shield for year 0 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 1 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 2 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 3 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 4 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 5 is $__________ million. (Round to two decimal places.)
d. If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which should it choose? Why?
A. With MACRS, the firm receives the depreciation tax shields sooner; thus, MACRS leads to a higher NPV of Markov’s FCF.
B. With straight-line depreciation, the firm’s depreciation expenses are lower initially, leading to higher earnings; thus, straight-line depreciation leads to a higher NPV of Markov’s FCF.
C. With either method, the total depreciation tax shield is the same; therefore, it does not matter which method is used.
D. None of the above.
e. How might your answer to part (d) changeif Markov anticipates that its marginal corporate tax will change substantially over the next five years?
A. Markov may be better off using the straight-line method if it expects its tax rate to decrease substantially in later years.
B. Markov may be better off using the straight-line method if it expects its tax rate to increase substantially in later years.
C. Even if its tax rate is expected to change, Markov is better off using MACRS depreciation rather than straight-line depreciation.
D. None of the above
10. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following free cash flow projections (in millions of dollars):
Free Cash Flow | Year 0 | Years 1-9 | Year 10 |
Revenues | 100.00 | 100.00 | |
–Manufacturing expenses (other than depreciation) | – 32.00 | – 32.00 | |
– Marketing expenses | – 8.00 | – 8.00 | |
– Depreciation | – 14.00 | – 14.00 | |
= EBIT | 45.60 | 45.60 | |
– Taxes (35%) | – 15.96 | – 15.96 | |
= Unlevered net income | 29.64 | 29.64 | |
+ Depreciation | |||
– Increases in net working capital | – 5.00 | – 5.00 | |
– Capital expenditures | – 144.00 | ||
+ Continuation value | 12.00 | ||
= Free cash flow | – 144.00 | 39.04 | 51.04 |
a. For this base case scenario, the NPV of the plant to manufacture lightweight trucks is $__________ million. (Round to two decimal places.)
b. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions.
The NPV of this project if revenues are 10% higher than forecast is $__________. (Round to two decimal places.)
The NPV of this project if revenues are 10% lower than forecast is $__________. (Round to two decimal places.)
Instructions: Either type or write your answers directly on this document and submit the completed assignment to your ESO. Show your work for the calculations. If you use additional documents for the calculations, label them with your name and course number (MBA 570) and submit them as well. Each question is worth 10 points.
1. You have been offered a very long-term investment opportunity. You can invest $1,100 today and expect to receive $128,000 in 40 years. Your cost of capital for this (very risky) opportunity is 16%.
a. The IRR of this investment opportunity is __________ %. (Round to one decimal place.)
The IRR rule says that you __________. (Select the best answer.)
A. should not invest
B. should be indifferent
C. should invest
b. The NPV of this investment opportunity is __________ %. (Round to the nearest cent.)
The NPV rule says that you __________. (Select the best answer.)
A. should not invest
B. should be indifferent
C. should invest
2. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The sign will cost $10,000 and will be posted for one year. You expect that it will generate additional revenue of $1,900 a month. The payback period is __________ months. (Round to two decimal places.)
3. You are considering making a movie. The movie is expected to cost $10.5 million upfront and take a year to make $4.9 million in the year it is released (end of year 2) and $1.7 million for the following four years (end of years 3 through 6).
a. The payback period of this investment is __________ years. (Round up to nearest integer.)
b. If you require a payback period of two years, would you make this movie?(Enter yes or no.)
c. If the cost of capital is 10.3%, the NPV is $__________ million.(Round to two decimal places.)
4. AOL is considering two proposals to overhaul its network infrastructure. They have two bids. The first bid from Huawei will require a $15 million upfront investment and will generate $20 million in savings for AOL each year for the next three years. The second bid from Cisco requires an $81 million upfront investment and will generate $60 million in savings each year for the next three years.
a. What is the IRR for AOL associated with each bid?
The IRR associated with the bid from Huawei is __________ %. (Round to one decimal place.)
The IRR associated with the bid from Cisco is __________ %. (Round to one decimal place.)
b. If the cost of capital for this investment is 14%, what is the NPV for each bid?
The NPVfor Huawei’s bid is $__________ million. (Round to two decimal places.)
The NPVforCisco’s bid is $__________ million. (Round to two decimal places.)
c. Suppose Cisco modifies its bid by offering a lease contract instead. Under the terms of the lease, AOL will pay $26 million upfront, and $35 million per year for the next three years. AOL’s savings will be the same as with Cisco’s original bid.
The IRR of the Cisco bid is now __________%. (Round to one decimal place.)
The new NPV is $__________ million. (Round to two decimal places.)
d. AOL should:
A. choose Huawei.
B. choose Cisco without lease.
C. choose Cisco with lease.
D. take none of the bids.
5. Natasha’s Flowers, a local florist, purchases fresh flowers each day at the local flower market. The buyer has a budget of $1,000 per day to spend. Different flowers have different profit margins, and also a maximum amount the shop can sell. Based on past experience the shop has estimated the following NPV for purchasing each type:
NPV per bunch | Cost per bunch | Max. bunches | |
Roses | $2 | $20 | 25 |
Lilies | $10 | $29 | 10 |
Pansies | $6 | $30 | 10 |
Orchids | $21 | $80 | 5 |
(Select based on descending order of their profitability-index values. Round the investment amounts to the nearest integer.)
The combination of flowers Natasha’s Flowers should purchase each day is(select one of the three for each):
$__________ of (roses, pansies, lilies) Select one of the three.
$__________ of (orchids, pansies, lilies) Select one of the three.
$__________ of (lilies, orchids, pansies) Select one of the thre
6. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $21 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 46% will come from customers who switch to the new, healthier pizza instead of buying the original version.
a. Assuming customers will spend the same amount on either version, the incremental sales associated with introducing the new pizza are $__________ million. (Round to the nearest integer.)
b. Suppose that 59% of the customers who will switch from Pisa Pizza’s original to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. In this case, the incremental sales associated with introducing the new pizza are $__________ million. (Round to the nearest integer.)
7. Cellular Access Inc. is a cellular telephone service provider that reported net operating profit after tax (NOPAT) of $259 million for the most recent fiscal year. The firm had depreciation expenses of $128 million, capital expenditures of $152 million, and no interest expenses. Working capital increased by $12 million. The free cash flow for Cellular Access for the most recent fiscal year is $__________ million.(Round to the nearest million.
8. Castle View Games would like to invest in a division to develop software for video games. To evaluate this decision, the firm first attempts to project the working capital needs for its operation. Its chief financial officer has developed the following estimates (in millions of dollars):
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Cash | 7 | 12 | 14 | 15 | 16 |
Accounts receivable | 18 | 22 | 23 | 22 | 25 |
Inventory | 4 | 9 | 10 | 12 | 16 |
Accounts payable | 16 | 19 | 25 | 28 | 32 |
Assuming that Castle View currently does not have any working capital invested in this division, calculate the cash flows associated with the changes in working capital for the first five years of this investment. (Note: Enter decreases as negative numbers.)
a. The change in working capital for year 1 is $__________ million.(Round to the nearest million.)
b. The change in working capital for year 2 is $__________ million. (Round to the nearest million.)
c. The change in working capital for year 3 is $__________ million. (Round to the nearest million.)
d. The change in working capital for year 4 is $__________ million. (Round to the nearest million.)
e. The change in working capital for year 5 is $__________ million. (Round to the nearest million.)
9. Markov Manufacturing recently spent $12 million to purchase some equipment used in the manufacturing of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 39%. The company plans to use straight-line depreciation.
a. The annual depreciation expense associated with this equipment is $__________ million. (Round to two decimal places.)
b. The annual depreciation tax shield is $__________ million.(Round to two decimal places.)
c. Rather than straight-line depreciation, suppose Markov will use the MACRS depreciation for five-year property. Calculate the depreciation tax shield each year for this equipment under the following accelerated depreciation schedule:
MACRS Depreciation Table | |
Year | 5 Years |
1 | 20.00% |
2 | 32.00% |
3 | 19.20% |
4 | 11.52% |
5 | 11.52% |
6 | 5.76% |
The depreciation tax shield for year 0 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 1 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 2 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 3 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 4 is $__________ million. (Round to two decimal places.)
The depreciation tax shield for year 5 is $__________ million. (Round to two decimal places.)
d. If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which should it choose? Why?
A. With MACRS, the firm receives the depreciation tax shields sooner; thus, MACRS leads to a higher NPV of Markov’s FCF.
B. With straight-line depreciation, the firm’s depreciation expenses are lower initially, leading to higher earnings; thus, straight-line depreciation leads to a higher NPV of Markov’s FCF.
C. With either method, the total depreciation tax shield is the same; therefore, it does not matter which method is used.
D. None of the above.
e. How might your answer to part (d) changeif Markov anticipates that its marginal corporate tax will change substantially over the next five years?
A. Markov may be better off using the straight-line method if it expects its tax rate to decrease substantially in later years.
B. Markov may be better off using the straight-line method if it expects its tax rate to increase substantially in later years.
C. Even if its tax rate is expected to change, Markov is better off using MACRS depreciation rather than straight-line depreciation.
D. None of the above.
10. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following free cash flow projections (in millions of dollars):
Free Cash Flow | Year 0 | Years 1-9 | Year 10 |
Revenues | 100.00 | 100.00 | |
–Manufacturing expenses (other than depreciation) | – 32.00 | – 32.00 | |
– Marketing expenses | – 8.00 | – 8.00 | |
– Depreciation | – 14.00 | – 14.00 | |
= EBIT | 45.60 | 45.60 | |
– Taxes (35%) | – 15.96 | – 15.96 | |
= Unlevered net income | 29.64 | 29.64 | |
+ Depreciation | |||
– Increases in net working capital | – 5.00 | – 5.00 | |
– Capital expenditures | – 144.00 | ||
+ Continuation value | 12.00 | ||
= Free cash flow | – 144.00 | 39.04 | 51.04 |
a. For this base case scenario, the NPV of the plant to manufacture lightweight trucks is $__________ million. (Round to two decimal places.)
b. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions.
The NPV of this project if revenues are 10% higher than forecast is $__________. (Round to two decimal places.)
The NPV of this project if revenues are 10% lower than forecast is $__________. (Round to two decimal places.)