Corporate Finance, Fall 03 E. Hotchkiss Exam # 1

Transcription

1 Corporate Finance, Fall 03 E. Hotchkiss Exam # 1 Name: Please read each question carefully, and neatly write all answers on this exam paper. It is very important that you show all work so that you can receive partial credit. Good luck! 1

2 1. Capital Budgeting (25 points). WPI Industries is considering replacing one of its existing machines with a new, more automated, more efficient machine. The existing machine has a $10,000 book value but it could be sold today for $40,000. It has an estimated remaining life of five years and is being depreciated to a zero book value. The new machine could be purchased for $210,000. Installation costs (fully tax deductible at time of purchase) would be an additional $5,000. It is estimated that this new machine would increase output by 10%, increasing sales revenue by $30,000 per year. In addition, this machine is expected to reduce operating costs by $35,000 annually. If purchased, this new machine would be used for five years, then sold for an estimated $25,000. It would be depreciated straight line to zero over five years. Blackstone pays tax at a rate of 40%, and its cost of capital is 15%. a. Find the projected free cash flows over the life of this project. b. What is the NPV of this project? c. What is the payback period (ordinary) of this project? a. ($000) Year 0 Years 1-5 Sales cost depr 0 42 EBIT tax depr 0 42 OCF OCF NWC Capex +40* *.6 FCF b. NPV@15% = c. Year Cumulative FCF ( )/55.8 =.39 2

3 PBP = 3.39 years 3

4 Decision Trees (30 points). Your company has a new project to be considered. You are given the following information on the best guess of related outcomes for the project. Before you can go into production, you need to test the product over the next year - this will cost $225 million today. After the one year test, the company can choose to spend another $800 million to put the productive capabilities in place. There is a 65% chance the test will indicate the cash flow from the product will be high. If so, the expected free cash flows are $475 million each year for the next six years (years 2 through 7) with an 80% probability and zero with a 20% probability. There is a 35% chance the test will indicate the cash flow from the product will be low. If so, the expected free cash flows for the next six years are $325 million per year. The company uses a 12% discount rate for these types of projects. a. Draw and label the decision tree. b. Determine the net present value and the decision to undertake testing or not. A) DECISION TREE High? --invest $800 mil.? --FCF=$475 mil (yrs 2-7).65? ?? ----NPV = 0? low? do not invest?.35? ??? ---invest $800 mil.---fcf=$325 mil(yrs 2-7) Do not test B. Determine NPV and decide whether or not to test: NPV 1 of investing at t=1 high = *(475* A t=6 r=.12 ) + 0.2*(0) = NPV 1 of investing at t=1 low = (325 * A t=6 r=.12 ) = NPV 0 = (0.65*762.33)/ (0.35*536.2)/1.12 = CONCLUDE: NPV 0 > 0, so undertake testing 4

5 2. Break even analysis (25 points). You are considering setting up a facility to manufacture computers. The manufacturing facility will cost $15 million to build and will have the capacity to sell 50,000 computers a year. Each computer is expected to sell retail for $2,800, and the cost of making each computer is expected to be $1,400. The fixed costs amount to $150,000 a year, not including depreciation, which is assumed to be straight line to zero over five years. The business will run for five years, at which time you estimate the market value of the facility to be zero. The discount rate is 10%, and the tax rate is 40%. a. Estimate the accounting and financial break even number of computers for this project. b. Now assume that at the end of 5 years, you could sell the facility for $5,000,000. Estimate the financial breakeven number of computers. 5

6 1. Capital Budgeting (25 points). The Autobody Express, Inc., is evaluating alternative uses for a warehouse building purchased for $500,000. If neither project is taken, the company will continue to rent the warehouse to its current tenants at $18,000 per year. The alternatives are: 1) Manufacture denim shirts. Since consumer tastes change relatively fast, the company expects to manufacture this product for only three years. They will have to spend $16,000 to modify the building for this project, and $44,000 for necessary equipment. They expect to generate $130,000 in sales for the following three years, at annual manufacturing costs of $82,000. 2) Manufacture cologne. To manufacture this product, the company will have to spend $24,000 to modify the building for this project, and $156,000 for necessary equipment. They expect to generate $175,000 in sales for the following three years, at annual manufacturing costs of $72,000. This project would also last three years. At the end of three years, the building will be restored to its original state, and rented to someone similar to the current tenant. The estimated cost of restoring the building will be $10,000 if the shirts are produced, and $20,000 if the cologne is produced; these costs are deductible for tax purposes in the year the expenditures occur. The equipment for either project will be worthless at the end of three years. The original warehouse will be depreciated over 30 years to zero, regardless of which project the firm takes. The building modifications and equipment will be depreciated straight line to zero over three years. The firm's tax rate is 40%, and the required rate of return on either investment is 12%. Assume all cash flows for a given year occur at the end of the year, and the initial outlays occur at t=0. Based on the NPV, which use of the building would you recommend and why? Shirts: OCF yrs 1-2 yr 3 Revenue foregone rent manufacturing costs depreciation EBIT tax depreciation* OCF OCF NWC CAPEX FCFF NPV@12% ($1.82) 6

7 Cologne: OCF yrs 1-2 yr 3 Revenue foregone rent manufacturing costs depreciation** EBIT tax depreciation OCF OCF NWC CAPEX FCFF NPV@12% ($8.40) *depreciation = (16+44)/3 **depreciation = (24+156)/3 Both options have negative NPV, so you should continue to rent. 1. Capital Budgeting (8 points). Shirts: OCF yrs 1-2 yr 3 Revenue foregone rent manufacturing costs depreciation EBIT tax depreciation* OCF OCF NWC CAPEX FCFF NPV@12% ($1.82) 7

8 Cologne: OCF yrs 1-2 yr 3 Revenue foregone rent manufacturing costs depreciation** EBIT tax depreciation OCF OCF NWC CAPEX FCFF NPV@12% ($8.40) *depreciation = (16+44)/3 **depreciation = (24+156)/3 Both options have negative NPV, so you should continue to rent. 8