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RSM333 - assignment 1 - Fall 2012.docx

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University of Toronto St. George
Rotman Commerce
Fotini Tolias

RSM333 - Assignment #1 - Fall 2012 You may work in groups of up to 3. Due 4pm at Rotman Commerce, October 10, 2012 50 MARKS TOTAL Question 1 - 10 marks Mad Cat Inc. is debating between two alternative earth moving machines to use for the next 8 years. The first supplier, Double Candle, offers the necessary machinery (CCA rate = 30%) at an upfront cost of $5,450,000. These machines are expected to last 4 years and then be salvaged for approximately $1,400,000 (the CCA pool remains open). All the Double Candle machines would be salvaged and replaced after 4 years. The alternative is to purchase significantly more expensive (but longer lasting) machinery from Elemental which would last the full 8 years but cost $8,650,000 and depreciate at the same CCA rate. Elemental's machines have an expected salvage value of approximately $1,800,000. Mad Cat pays a 25% tax rate and its cost of capital is 11%. a) Which of the two systems incurs the lowest overall cost for Mad Cat? (4 marks) b) Making projections about cash flows in the future can be quite a difficult task for junior analysts. For what salvage value on the Elemental machines would you be indifferent between the two options? (2 marks) c) At what price for the Elemental machines would you be indifferent between the two options (assuming $1,000,000 in salvage regardless of the purchase price). (2 marks) d) How would you feel about your original decision in part a) if Element instead offered to let you finance the purchase for $1,450,000 per year for 8 years with each payment made at the beginning of each year. The arrangement would enable Mad Cat to depreciate the asset as though it was owned the entire time, and to salvage it at the end of its useful life (a financial lease - the payments are not tax deductible). (2 marks) Question 2 - 10 marks Frozen Waste Oilfields is a new producer of crude oil from frozen tar sand deposits, able to extract 2,500,000 barrels of oil each year at a cost of roughly $40 per barrel. In addition, the firm incurs $10 million in unavoidable overhead each year. Its cost of capital is 18% and its tax rate is 35% a) If it can suspend operations, below what price should the firm cease producing output? (2 marks) b) Although oil prices have recently fallen to approximately $45 per barrel, the firm's forecasters believe that over the next year, there is a 30% chance that the average price per barrel will rise to $60, a 45% chance the price will stay at $45, and a 25% chance the price falls to $35. Frozen Waste pays a 30% tax rate and all cash flows take place at the end of the year. Assuming the firm will know at the beginning of the year what the price of its output will be, what is the value of the option for it to suspend operations for a year? (8 marks) Question 3 - 10 marks The engineering department of your firm is developing a clever new production system which it believes could be put into use immediately, despite the fact that it has not been fully tested (and thus its ultimate benefits remain uncertain for the time being). The Skynet mainframe will control all aspects of the production system and while it will incur an initial cost of $10 million dollars to set up, it is expected to reduce operating costs by $2 million a year for the next 15 years. Work in progress inventory will be reduced by $2 million (one time) by the end of the first year with a further improvement of $1 million expected in the second year (also a one-time improvement). As the system could be perpetuated for the foreseeable future, these reductions in working capital would be permanent. Skynet will have an 8% CCA rate (pool remains open)
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