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As a budding entrepreneur, you generate a brilliant idea. You know that Georgetown

has a large population of geriatrics who love Reader’s Digest. You pitch the idea to the

publisher of the magazine of producing CD-ROM’s that will contain the text of all of the

articles published in it since the first issue. You provide the publisher with the following

information in the proposal:

• You have will to complete market testing for the product to prove that there is a

market for the electronic versions of the magazine. This market testing will cost $ 5

million in Year 0.

• Reader’s Digest will have to invest $ 25 million in new computers, CD-ROM drives and

other equipment. This equipment will have a life of 4 years, at the end of which it is

estimated to have an after-tax salvage value of $ 5 million. You assume you will sell the

equipment in the fifith year.

• During the 4-year period, the computers will be depreciated straight-line down to its

after-tax salvage value of $5 million. You would then sell the computers.

• It is anticipated that 300,000 CD-ROMs will be sold each year for the next 4 years, at a

price of $ 50 per CD-ROM. The cost of producing and packaging each CD is $ 10.

• There will be 10 full time employees and the total payroll for these employees is

expected to be $ 2 million per year for the next 4 years.

• The firm will have to maintain a level of working capital for the project equal to 10%

of revenues. This investment will have to be made at the beginning of the first year, and

will be entirely recovered in the fifth year.

• The total annual advertising budget for Reader’s Digest, which is currently $ 25

million each year, is expected to increase to $ 27.5 million each year as it advertises for

the new CD-ROMs.

• The firm has a tax rate of 35%.

• Projects this risky in the past have returned 13% for Reader’s Digest.

a. Does the magazine reject your offer? Why or why not?

b. Instead of CD-ROMS, you offer to place the old magazines on jump drives. This would

reduce the number of computers needed, reducing the amount spent on them from $25

million to $20 million. If you can depreciate this new amount of computers down to an

after-tax salvage value of $4 million, would that affect their decision at all?

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Reid Wolff
Reid WolffLv2
6 Mar 2019

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Use the information here for the following 7 questions (7-13).

Warf Computers needs specialized equipment for production.

The company can buy the equipment from Clapton Acoustical Equipment for $5 million.


The equipment falls in the three-year MACRS depreciation class.
MACRS Depreciation Allowances
Property Class
Year 3-year 5-year 7-year
1 33.33% 20.00% 14.29%
2 44.44% 32.00% 24.49%
3 14.82% 19.20% 17.49%
4 7.41% 11.52% 12.49%
5 11.52% 8.93%
6 5.76% 8.93%
7 8.93%
8 4.45%
At the end of four years, market value of the equipment is expected to be $600,000.

Alternatively, the company can lease from Hendrix Leasing. Lease contract calls for four annual payments of $1.3 million due at the beginning of the year.

Security deposit of $300,000 will be returned when the lease expires.
Warf Computers can issue bonds with a yield of 11 percent and the company has a marginal tax rate of 35%.

If Warf leases, what is the after-tax lease payment in year 3?

If Warf leases, what is the lost after-tax salvage value in year 4?

If Warf leases, what is the lost depreciation tax shield in year 2?

If Warf leases, what is the incremental cash flow in year 0?

If the lease contract includes an option for Warf to purchase the equipment at its fair market value upon the lease’s expiration, how will the option influence the value of the lease?

If the lease contract includes a cancellation option that allows Warf to cancel the lease with 30 days’ notice, how will the option influence the value of the lease?

If the lease contract includes an option for Warf to purchase the equipment at $250,000 upon the lease’s expiration, how will the option influence the value of the lease?

S & P Corporation (SPC) is considering entering a new line of business. In analyzing the potential business, the financial staff has accumulated the following information: • The new business will require a capital expenditure of $5.5 million at t = 0. This expenditure will be used to purchase new equipment. • This equipment will be depreciated according to MACRS five-year class (see table next page). • The equipment will have a salvage value of $500,000 after five years. • If SPC goes ahead with the new business, inventories will rise by $300,000 whereas accounts payable will rise by $200,000 (both at t = 0). As a matter of fact, the required level of working capital is 2.5% of expected sales over the year: WCt = 2.5%*Salest+1 • The new business is expected to have an economic life of five years. • The Marketing Department forecasts to sell 300,000 units during the first year and then 400,000 units thereafter. The expected price is $10 per unit during the first year. Price must be adjusted by inflation in subsequent years. • During the first year, variable cost is expected to be $5.50 per unit whereas fixed cost is $100,000. These figures must be adjusted by inflation in subsequent years. • The new product is expected to increase before-tax cash flows of the company’s existing products by $300,000 per year in real terms. This amount also has to be adjusted by inflation. • The expected inflation rate during the life of the project is 2% per year. • The company’s interest expense each year will be $220,000. • The company’s tax rate is 40%. • The company is very profitable, so any accounting losses on this project can be used to reduce the company’s overall tax burden. • The company’s cost of capital (WACC) is 6.80%. However, the proposed project is riskier than the average project for SPC and therefore you have to add 2% to the corporate cost of capital. The company’s CFO wants you to analyze the project and to write a short report with your recommendation. Please be advised that the report will be read by both financial and non-financial managers, therefore, make sure you explain your calculations and recommendation. MACRS 5-year class Depreciation Year Rates 1 0.20 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06

This is a comprehensive project evaluation problem bringing together much of what you have learned so far. Company ABC is a large publicly traded firm, a market leader in producing selfdriving agricultural machines. The company is looking at setting up a manufacturing plant overseas to produce a new line of self-driving tractors. This will be a four-year project. The plant and equipment will cost $100 million to build. The market data on ABC’s securities is following: Debt: 550,000 5.6 percent coupon bonds outstanding, 20 years to maturity, selling for 108 percent of par; the bonds have a $1,000 par value each and make semiannual payments. Common stock: 22,000,000 shares outstanding, selling for $56 per share; the beta is 1.1. Preferred stock: 1,200,000 shares of 5 percent preferred stock outstanding, selling for $85 per share. Market: 7 percent expected market risk premium; 3 percent risk-free rate. ABC faces 8 percent floatation costs of new common stock issues, 6 percent on new preferred stock issues, and 4 percent on new debt issues. ABC’s tax rate is 35 percent. The project requires $5,5 million in initial net working capital investment to get operational. a. Calculate the weighted average of floatation costs and use this to adjust your initial investment. b. The new project is somewhat riskier than a typical project for ABC, primarily because the plant is being located overseas. Management has decided to use adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating ABC’s project (start by calculating WACC). c. The manufacturing plant has a four-year tax life, and ABC uses straight-line depreciation. At the end of the project (that is, the end of Year 4), the plant and equipment can be scrapped for $20 million. What is the aftertax salvage value of this plant and equipment? d. The company will incur $16 million in annual fixed costs. The plan is to manufacture 2,000 tractors per year and sell them at $110,000 per machine; the variable production costs are $75,000 per tractor. Confirm that annual operating cash flows (OCF) from this project are $43.85 million. e. Confirm that the last year’s (year 4) total cash flow from assets is $62.35 million (don’t forget to add in the net working capital and after tax salvage value). f. Given the following total cash flows of years 0-4: -112,637,300; 43,850,000; 43,850,000; 43,850,000; and 62,350,000 what is the project’s internal rate of return (IRR) and net present value (NPV). Would you recommend to invest into this project?

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