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University of Toronto Scarborough
Derek Chau

  MGTB09H3 – Principles of Finance  Fall 2010  Additional self­study exercises topic 5 – Capital budgeting            answers at the end     Questions Question 1 (Capital Budgeting) Rick Lee and Jane Smith are considering building a new bottling plant to meet expected future demand for their new line of tropical coolers. They are considering putting it on a plot of land they have owned for three years. They are analyzing the idea and comparing it to some others. Rick says, “Jane when we do this analysis, we should put in an amount for the cost of the land equal to what we paid for it. After all it did cost us a pretty penny.” Jane retorts, “No, I do not care how much it cost – we have already paid for it. It is what they call a sunk cost. The cost of land shouldn’t be considered.” As financial advisor to Lee and Smith, what do you say?   Question 2 (Capital Budgeting) Jocelyn Chen & Bosco Lau Toys has developed a new children’s toy. Revenues are forecasted as follows: Yea1r 2 3 4 thereafter ExpeRctvenu$4s0,000 $30,000 $20,000 $10,000 0 Expenses are expected to be 40% of the revenues, and working capital required in each year is expected to be 20% of the revenues of the following year. The product requires an immediate investment of $50,000 in plant and equipment. The expected salvage value of the plant and equipment at the end of 4 years is $23,040. In addition, the firm spent $15,000 developing the new toy. Plant and equipment can be depreciated on a declining balance basis at 20% per year (class 8 asset pool). The company has many other assets in the class 8 pool. The corporate tax rate is 40% and the opportunity cost of capital is 12%. a. What is the project’s NPV? b. What other issues should be considered before deciding to go ahead with the project? c. What would be the effect on the project’s NPV if the salvage value of the plant and equipment was $5,000? d. The forecasts were made without any consideration of inflation. If the expected annual inflation rate is 4%, recalculate the NPV to incorporate its effect assuming 1. 12% is the nominal rate of return, and 2. 12% is the real rate of return 1   Question 3 (Capital Budgeting) Jimmy Wong of Wong & Tran Construction Limited is feeling nervous. The anxiety is caused by a new excavator just released onto the market. The new excavator makes the one purchased by the company a year ago obsolete. As a result, the market value of the company’s excavator has dropped significantly, from $250,000 a year ago to $100,000 now. In 10 years, it would be worth only $20,000. The new excavator costs only $200,000 and would increase operating revenues by $20,000 annually. The new equipment has a 10 year life and expected salvage value of $40,000. What should the officer do? The tax rate is 42%, the CCA is rate is 30% for both excavators and the required rate of return to the company is 12%. Assume the asset class remains open. Question 4 (Capital Budgeting) Setting the Bid Price: Toronto police is asking for bids on speed radars. The contract calls for 4 speed radars to be delivered each year for the next 4 years. Labor and material costs are estimated to be $10,000 per radar. Production space can be leased for $12,000 per year. The project requires $50,000 in new class 8 equipment that is expected to have a salvage value of $5,000 at the end of the project and has an applicable CCA rate of 20% (assume the asset class remains open). Making the radars will mean a $10,000 increase in net working capital that will be recovered at the end of the project. The tax rate is 40% and the required rate of return is 15%.   2   Solutions Answer 1 (Capital Budgeting) The purchase price of the land is indeed a sunk cost and should not be included in the analysis. However, there may be some opportunity costs, as Rick and Jane may be able to sell the land rather than building a new plant on it. The price for which they would be able to sell the land today (i.e. the market value today) should be included in the analysis as an opportunity cost. Answer 2 (Capital Budgeting) a. Investment at t=0 is $50,000 Yr Revenue – costs – tax 1 $40,000(1-0.40)(1-0.40) 2 30,000(1-0.40)(1-0.40) 3 20,000(1-0.40)(1-0.40) 4 10,000(1-0.40)(1-0.40) Yr Total NWC Required 0 0.20(40,000) = $8,000 1 0.20(30,000) = 6,000 2 0.20(20,000) = 4,000 3 0.20(10,000) = 2,000 4 0.20(0) PV of ATNOR = 14,400/(1.12) + 10,800/(1.12) + 7,200/(1.12) + 3,600/(1.12) = 12,857 + 8610 + 5125 + 2,288 PV of Inv. in NWC = 8,000 – 2,000/1.12 –2,000/(1.12) –2,000/(1.12) – 2,000/(1.12) = 8,000 – 1,786 – 1,594 –1,424 – 1,271= PV of CCA tax shield (asset class remains open): ) . ( ) . ( ⎛CdT ⎛1+ . r PVofCCATS = ⎜ ⎝ ⎝dr+ 1 + r = 11,830 – 3,661 = $8,169 PV of Salvage Value = 23,040/(1.12) SUMMARY Investment -$50,000 PV of ATNOR
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