Capital Budgeting

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MGTB09H3PrinciplesofFinance Winter2010 Additionalselfstudyexercisestopic5Capitalbudgeting answersattheend 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 shouldnt 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 childrens toy. Revenues are forecasted as follows: Year 1 2 3 4 thereafter Expected Revenues $40,000 $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 projects NPV? b. What other issues should be considered before deciding to go ahead with the project? c. What would be the effect on the projects 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
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