Exam 12: Strategy and the Analysis of Capital Investments

Brandon Company is contemplating the purchase of a new piece of equipment for $45,000. Brandon is in the 30% income tax bracket. Predicted annual after-tax cash inflows from this investment are $18,000, $15,000, $9,000, $6,000 and $3,000 for years 1 through 5, respectively. The firm uses straight-line depreciation with no residual value at the end of five years. Assume that the hurdle rate for accepting new capital investment projects for the company is 4%, after-tax. (Note: PV $1 factors for 4% are as follows: for year 1 = 0.962, for year 2 = 0.925, for year 3 = 0.889, for year 4 = 0.855, for year 5 = 0.822; the PV annuity factor for 4%, 5 years = 4.452.) At an after-tax discount rate of 4%, the estimated PV (present value) payback period, in years (rounded to two decimal places) is:

Which of the following can a cash flow analysis of the final disposal of a capital asset (for example, machinery used in the operation of a business) not produce?

Quip Corporation wants to purchase a new machine for $300,000. Management predicts that the machine will produce sales of $200,000 each year for the next 5 years. Expenses are expected to include direct materials, direct labor, and factory overhead (excluding depreciation) totaling $80,000 per year. The firm uses straight-line depreciation with an assumed residual (salvage) value of $50,000. Quip's combined income tax rate, t, is 40%. Management requires a minimum after-tax rate of return of 10% on all investments. What is the approximate internal rate of return (IRR) of the proposed investment? (Note: To answer this question, students must have access to Table 2 from Appendix C, Chapter 12.) Assume that all cash flows occur at year-end.

Quip Corporation wants to purchase a new machine for $300,000. Management predicts that the machine will produce sales of $200,000 each year for the next 5 years. Expenses are expected to include direct materials, direct labor, and factory overhead (excluding depreciation) totaling $80,000 per year. The firm uses straight-line depreciation with an assumed residual (salvage) value of $50,000. Quip's combined income tax rate, t, is 40%. What is the annual accounting (book) rate of return (ARR) for the proposed investment, based on the initial investment? (Round answer to nearest whole percentage.)

The accounting rate of return (ARR):

XYZ Corporation's capital structure consists of 60% debt (with a pretax cost of 10%), and the balance of common equity (with a cost of 15%). The company's income tax rate (federal and state combined), t, is 40%. XYZ's weighted-average cost of capital (WACC), to one decimal point, is:

HHR Construction, Inc. is 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 in approximately a year from now new information regarding potential consumer demand would be revealed, that is, whether in the chosen geographic location a courtyard motel would be popular (i.e., "good news") or unpopular (i.e., "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. Required: 1. Based on the given probabilities for the two possible outcomes (states of nature), what is the expected NPV of the proposed investment, rounded to the nearest whole dollar? (At 10%, PV factor for one year = 0.909.) 2. What is the primary deficiency of the traditional DCF analysis you conducted above in Requirement (1)? 3. 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? That is, what is the expected NPV of the proposed investment (today) if we waited one year? (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.) Round your answer to the nearest whole number. 4. Define the term "real option." Compare real options with financial options. 5. This problem deals with what is called an investment-timing option, one of four general classes of real options. What other types of real options can be embedded in a capital investment proposal? How do these classes relate to put options and call options?