12.08 NEW PROJECT ANALYSIS

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $240,000, and it would cost another $36,000 to modify the equipment for special use by the firm. The equipment falls into the MACRS 3-year class and would be sold after 3 years for $60,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $5,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $70,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.

1. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent. Negative amount should be indicated by a minus sign.
   $

2. What are the project's annual cash flows in Years 1, 2, and 3? Round your answers to the nearest cent.

   In Year 1 $

   In Year 2 $

   In Year 3 $

3. If the WACC is 12%, should the spectrometer be purchased?
   -Select-YesNoItem 5

Mountain Sky Inc. announced today it will grow its dividend by 30% for the next 2 years and then it's growth will continue indefinitely at 3% thereafter. Mountain Sky is expected to pay dividend in one year of $5. If you believe the appropriate required rate of return on the stock is 15% what would you be willing to pay for the stock?

A stock is currently trading at 36$/share, has annual volatility of 17% and pays no dividends. The risk-free rate is 6% p.a. continuously compounded and an option trader writes a three-month call which is $4 out-of-the money. What should be the price of this call? What should be the price of this call as a percentage of the current stock price?

What are some areas that financial advisors will test their image based on target market

1. Use the following information to design a life-cycle income-spending-saving plan:

• Initial age is 23 when income is $46,000.

• Inflation is 0% so all increases are real rates.

• Income grows by 3% annually except on decade birthdays (e.g. 30, 40, etc.) when it jumps by 15%.

• The person works until age 68.

• Any savings (wealth) grows at 5% annually.

• Taxes take 25% of gross income each year. Savings are 15% of net (after-tax) income.

• There is no Social Security or other government programs.

• How much will they have saved (wealth) at age 68?

• How long will their retirement wealth last if their retirement spending is 75% of their last work year’s spending?

In 20YY , Australia’s BHP Billiton Limited’s put a bid for Britain’s Rio Tinto plc. This hostile takeover attempt, if successful, would have been the third largest takeover in history. However the failure left both companies feeling bruised and battered. The merger was opposed on anti-trust grounds with the proposal that the merger would actually raise the price of iron ore and other key products. Where are the synergies, or cost savings, expected from the merger?

1. Basic concepts

Finance, or financial management, requires the knowledge and precise use of the language of the field. Match the terms relating to the basic terminology and concepts of the time value of money on the left with the descriptions of the terms on the right. Read each description carefully and type the letter of the description in the Answer column next to the correct term. These are not necessarily complete definitions, but there is only one possible answer for each term.

Term

Answer

Description

Discounting

A. A 6% return that you could have earned if you had made a particular investment.

Time value of money

B. A cash flow stream that is generated by a share of preferred stock that is expected to pay dividends every quarter indefinitely.

Amortized loan

C. A concept that maintains that the owner of a cash flow will value it differently, depending on when it occurs.

Ordinary annuity

D. An interest rate that reflects the return required by a lender and paid by a borrower, expressed as a percentage of the principal borrowed.

Annual percentage rate

E. The process of determining the present value of a cash flow or series of cash flows to be received or paid in the future.

Annuity due

F. A cash flow stream that is created by an investment or loan that requires its cash flows to take place on the last day of each quarter and requires that it last for 10 years.

Perpetuity

G. A series of equal cash flows that occur at the beginning of each of the equally spaced intervals (such as daily, monthly, quarterly, and so on).

Future value

H. One of the four major time value of money terms; the amount to which an individual cash flow or series of cash payments or receipts will grow over a period of time when earning interest at a given rate of interest.

Amortization schedule

I. A type of security that is frequently used in mortgages and requires that the loan payment contain both interest and loan principal.

Opportunity cost of funds

J. A table that reports the results of the disaggregation of each payment on an amortized loan, such as a mortgage, into its interest and loan repayment components.

Time value of money calculations can be solved using a mathematical equation, a financial calculator, or a spreadsheet. Which of the following equations can be used to solve for the present value of an ordinary annuity?

a. PMT x {[(1 + r)^n – 1]/r} x (1 + r)

b. PMT/r

c. PMT x {[(1 + r)^n– 1]/r}

d. PMT x {1 – [1/(1 + r)^n]}/r

A pharmaceutical company will spend $1,500,000 each year for 3 years to develop a new drug (years 0, 1, 2). After that (starting year 3), they will earn $900,000 in profits per year for 8 years before thepatent runs out. No extra profits after the patent is gone. If future payments are discounted using a 10% interest rate (compounded annually), is this new drug a profitable venture? Should you lease or buy equipment?

Company A can borrow fixed at 14.8 percent and floating at LIBOR percent. Company B can borrow fixed at 16.2 percent and floating at LIBOR+ 0.35 percent. A financial intermediary charges a fee of 0.14 percent. Company A wishes to borrow floating and company B wishes to borrow fixed. Assume the gain is evenly split between the two parties and floating rate legs are LIBOR. Design the swap. What is the company A's fixed rate leg and company B's fixed rate leg, respectively.

(Extra Credit) What is the value of the following cash flows in year 6? What is the value today? Assume interest rates today are 6.5%, then rates will be 6.25% for the next 4 years, 3.75% for the next 3 years, 5.3% for the next 4 years, and 3.75% thereafter.

Year Cash Flow

6 $5,675

8 $9,725

10 $6,750

17 $11,750

Investors expect the following series of dividends from a particular common stock: Year 1 $0.95 Year 2 $1.03 Year 3 $1.18 Year 4 $1.24 Year 5 $1.32 After the 5th year, dividends will grow at a constant rate. If the required rate of return on the stock is 8% and the current market price is $47.86, what is the long-term rate of dividend growth expected by the market?

You are considering investing in a $1000 face value 8% semi-annual coupon bond with 3 years left to maturity. Similar bonds are yielding 9.5% in the market, so the current price of this bond is _______, and if market interest rates drop to 8.25% the selling price of the bond would _____________

The Bigbee Bottling Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The old machine has a book value of $600,000 and a remaining useful life of 5 years. The firm does not expect to realize any return from scrapping the old machine in 5 years, but it can sell it now to another firm in the industry for $250,000. The old machine is being depreciated by $120,000 per year, using the straight-line method.

The new machine has a purchase price of $1,200,000, an estimated useful life and MACRS class life of 5 years, and an estimated salvage value of $145,000. The applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labor, and repair costs, as well as to reduce the number of defective bottles. In total, an annual savings of $200,000 will be realized if the new machine is installed. The company's marginal tax rate is 35%, and it has a 12% WACC.

1. What initial cash outlay is required for the new machine? Round your answer to the nearest dollar. Negative amount should be indicated by a minus sign.
   $
   
2. Calculate the annual depreciation allowances for both machines and compute the change in the annual depreciation expense if the replacement is made. Round your answers to the nearest dollar.

   Year	Depreciation Allowance, New	Depreciation Allowance, Old	Change in Depreciation
   1	$	$	$
   2
   3
   4
   5

3. What are the incremental net cash flows in Years 1 through 5? Round your answers to the nearest dollar.

   Year 1	Year 2	Year 3	Year 4	Year 5
   $	$	$	$	$

4. Should the firm purchase the new machine?
   -Select-Yes or No
   
   Support your answer.
   
5. In general, how would each of the following factors affect the investment decision, and how should each be treated?
   1. The expected life of the existing machine decreases. 2. The WACC is not constant, but is increasing as Bigbee adds more projects into its capital budget for the year.