Question
In: Finance
The Masterson, Inc. is considering the purchase of a piece of equipment whose upfront cost is...
- The Masterson, Inc. is considering the purchase of a piece of
equipment whose upfront cost is $65 million. The company estimates
that the result of operating this equipment could go one of two
ways: it could be highly successful and produce EBIT of $15 million
in year one and that EBIT grows at 3.42% per year for nine more
years; or it could be a poor performer and produce only $5 million
in EBIT in year one and that will grow by only 2.12% per year over
the remaining useful life of ten years. The machine will be
depreciated on a straight line basis over its useful life down to a
book value of $9 million. The expected salvage value of the machine
at the end of year ten is $11 million. The company’s marginal tax
rate is 25% and its RRR or WACC is 16%. The company assigns a 38%
chance to success.
- Given the above information and based on static analysis, should the company go ahead with its investment?
- Upon further study the company realizes that, if the project proved to be underperforming by the end of year one, the company can stop production and sell the machine for a salvage value of $61 million. Given this information, should the company go ahead with the investment?
- What is the present value of the option to abandon?
Solutions
Expert Solution
A. Possibility of Success = 38%. Therefore, possibility of failure = 62%.
If we draw a diagram of the success or failure it would look like below:
We need to find the cashflow for each of the options and then take a weighted average of the cashflow by multiplying them by the probabilities.
When it is static analysis, it means that once the decision is taken, the entire scenario - till year 10 cannot be changed.
Therefore, the cash flows for the 2 choices are presented below:
When company does well:
when Company does not do well
Therefore, taking the weighted NPV = 38% * 5.20 + 62%*-36.39 = - 20.58 Million. Based on Static Analysis the company SHOULD NOT go ahead with the project. However, if the company stops the project when it goes bad in the first year, then the NPV for failure is as below:
In this case, the weighted NPV = -3.23 Million The value of the option = NPV with the Option - NPV without the option = -3.23 + 20.58 = 17.24 Million |
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
when Company does not do well
| EBIT Growth | 2.12% | ||||||||||
| Tax | 25.00% | ||||||||||
| WACC | 16.00% | ||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Investment | (65) | (59) | (54) | (48) | (43) | (37) | (31) | (26) | (20) | (15) | (9) |
| EBIT | 5 | 5.11 | 5.21 | 5.32 | 5.44 | 5.55 | 5.67 | 5.79 | 5.91 | 6.04 | |
| Depreciation | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | |
| Plus: Profit from Sale of Asset | 2 | ||||||||||
| PBT | (1) | (0) | (0) | (0) | (0) | (0) | 0 | 0 | 0 | 2 | |
| Tax | (0.15) | (0.12) | (0.10) | (0.07) | (0.04) | (0.01) | 0.02 | 0.05 | 0.08 | 0.61 | |
| PAT | (0.45) | (0.37) | (0.29) | (0.21) | (0.12) | (0.04) | 0.05 | 0.14 | 0.24 | 1.83 | |
| Plus: Depr | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | 5.6 | |
| Plus: Sale of Asset | 9 | ||||||||||
| Cash Flow | (65) | 5.15 | 5.23 | 5.31 | 5.39 | 5.48 | 5.56 | 5.65 | 5.74 | 5.84 | 16.43 |
| Discount Factor | 1.000 | 0.862 | 0.743 | 0.641 | 0.552 | 0.476 | 0.410 | 0.354 | 0.305 | 0.263 | 0.227 |
| NPV | -36.39 |
Therefore, taking the weighted NPV = 38% * 5.20 + 62%*-36.39 = - 20.58 Million. Based on Static Analysis the company SHOULD NOT go ahead with the project.
However, if the company stops the project when it goes bad in the first year, then the NPV for failure is as below:
| EBIT Growth | 2.12% | |
| Tax | 25.00% | |
| WACC | 16.00% | |
| Year | 0 | 1 |
| Investment | (65) | (59) |
| EBIT | 5.00 | |
| Depreciation | 5.60 | |
| Plus: Profit from Sale of Asset | 2.00 | |
| PBT | 1.40 | |
| Tax | 0.35 | |
| PAT | 1.05 | |
| Plus: Depr | 5.60 | |
| Plus: Sale of Asset | 59.00 | |
| Cash Flow | (65) | 65.65 |
| Discount Factor | 1.000 | 0.862 |
| NPV | -8.41 |
In this case, the weighted NPV = -3.23 Million
The value of the option = NPV with the Option - NPV without the option
= -3.23 + 20.58 = 17.24 Million
jeff jeffy answered 2 years agoRelated Solutions
A company is considering the purchase of a piece of equipment that would cost $380,000 and...
A company is considering the purchase of a piece of equipment
that would cost $380,000 and would last for 8 years. At the end of
8 years, the equipment would have a salvage value of $97,500. The
equipment would provide annual cost savings of $85,000. The company
requires a minimum pretax return of 12% on all investment projects.
(Ignore income taxes.)
Required:
Provide your Excel input and the final net present value amount
you calculated. (If a variable is not...
ben is considering the purchase of new piece of equipment. the cost savings from the equipment...
ben is considering the purchase of new piece of equipment. the
cost savings from the equipment would result in an annual increase
in net income of $200000. the equipment will have an initial cost
of $1200000 and have an 8 year life. the salvage value of the
equipment is estimated to be $200000. the hurdle rate is 10%. what
is accounting rate of return? b) what is the payback period? c)
what is the net present value? d) what would...
6) Company is considering the purchase of a piece of equipment in '12. The projected cost...
6)
Company is considering the
purchase of a piece of equipment in '12.
The projected cost of the equipment is
50,000
The equipment will be depreciated via the MACRS - 5
year life
This equipment is expected to generate the
following economics:
Revenue for first year will be
45,700
Revenue will increase by
1.0%
per year thereafter
Expenses for first year will be
29,700
Expenses will decrease by
1.0%
per year thereafter
Company's Capital Structure is as follows:...
Clyde Corp. is considering the purchase of a new piece of equipment. The cost savings from...
Clyde Corp. is considering the purchase of a new piece of
equipment. The cost savings from the equipment would result in an
annual increase in cash flow of $101,100. The equipment will have
an initial cost of $601,100 and have an 8 year life. The equipment
has no salvage value. The hurdle rate is 8%. Ignore income taxes.
(Future Value of $1, Present Value of $1, Future Value
Annuity of $1, Present Value Annuity of $1.) (Use
appropriate factor from...
Briar Corp. is considering the purchase of a new piece of equipment. The cost savings from...
Briar Corp. is considering the purchase of a new piece of
equipment. The cost savings from the equipment would result in an
annual increase in cash flow of $217,000. The equipment will have
an initial cost of $1,217,000 and have an 8-year life. The salvage
value of the equipment is estimated to be $217,000. The hurdle rate
is 6%. Ignore income taxes. (Future Value of $1, Present
Value of $1, Future Value Annuity of $1, Present Value Annuity of
$1.)...
Grove Corp. is considering the purchase of a new piece of equipment. The cost savings from...
Grove Corp. is considering the purchase of a new piece of
equipment. The cost savings from the equipment would result in an
annual increase in net income of $200,300. The equipment will have
an initial cost of $1,200,300 and have an 8 year life. The salvage
value of the equipment is estimated to be $200,300. The hurdle rate
is 12%. Ignore income taxes. (Future Value of $1, Present Value of
$1, Future Value Annuity of $1, Present Value Annuity of...
Wilson Corp. is considering the purchase of a new piece of equipment. The cost savings from...
Wilson Corp. is considering the purchase of a new piece of
equipment. The cost savings from the equipment would result in an
annual increase in net income after tax of $50,000. The equipment
will have an initial cost of $626,000 and have an 8 year life. The
salvage value of the equipment is estimated to be $114,000. If the
hurdle rate is 11%, what is the approximate net present value?
can you please explain everything step by step as to...
Briar Corp. is considering the purchase of a new piece of equipment. The cost savings from...
Briar Corp. is considering the purchase of a new piece of
equipment. The cost savings from the equipment would result in an
annual increase in cash flow of $208,000. The equipment will have
an initial cost of $1,208,000 and have an 8 year life. The salvage
value of the equipment is estimated to be $208,000. The hurdle rate
is 6%. Ignore income taxes. (Future Value of $1, Present Value of
$1, Future Value Annuity of $1, Present Value Annuity of...
TA, Inc. is considering replacing a piece of old equipment with a piece of new equipment....
TA, Inc. is considering replacing a piece of old equipment with
a piece of new equipment. Details for both are given below:
Old Equipment
New Equipment
Current book value
$1,500,000
Current market value
$2,500,000
Acquisition cost
$6,200,000
Remaining life
10 years
Life
10 years
Annual sales
$350,000
Annual sales
$850,000
Cash operating expenses
$140,000
Cash operating expenses
$500,000
Annual depreciation
$150,000
Annual depreciation
$620,000
Accounting salvage value
$0
Accounting salvage value
$0
Expected salvage value after 10 years
$240,000
Expected...
TA, Inc. is considering replacing a piece of old equipment with a piece of new equipment....
TA, Inc. is considering replacing a piece of old equipment with
a piece of new equipment. Details for both are given below:
Old Equipment
New Equipment
Current book value
$1,800,000
Current market value
$2,500,000
Acquisition cost
$6,200,000
Remaining life
10 years
Life
10 years
Annual sales
$350,000
Annual sales
$850,000
Cash operating expenses
$140,000
Cash operating expenses
$500,000
Annual depreciation
$180,000
Annual depreciation
$620,000
Accounting salvage value
$0
Accounting salvage value
$0
Expected salvage value
$240,000
Expected salvage value
$750,000...
ADVERTISEMENT
ADVERTISEMENT
Latest Questions
- Enumerations Create an advanced enumeration to represent months (JANUARY – DECEMBER) called enuMonths Add internal properties...
- What is the minimum size of the automorphism group of a simple directed graph having more...
- The birthday paradox says that the probability (chance) that two people in a room will have...
- #include <iostream> #include "lib.hpp" using namespace std; int main() { // declare the bool bool...
- Why do we compare means instead of individual scores? for comparing average SAT test scores across...
- NPV Your division is considering two projects with the following cash flows (in millions): 0...
- The equivalent synchronous impedance of a 25kVA, 400V three-phase Y-connected synchronous generator is 0.05 + j1.6...
ADVERTISEMENT