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MY PROJECT :

The financial problems include investment risks, procurement of loan from banks and their repayment, meeting day to day expenses and the like.

The production problems include raw material availability, capacity utilization, and storage problems.

Finance problems relate to both liquidity and investment funds.

Firstly, liquidity is often very low, because turnover is also low; and secondly, much money is tied up in stocks of raw materials that are often bought in unnecessarily large quantities due to their uncertain availability. The liquidity problem also prevails amongst some of these units because the enterprises are just supplementary sources of income to agriculture and so receive only limited attention. Long-term investment finance is also not readily available. Yet most small industrialists cannot secure loans from financial institutions because they lack proper financial records from which assessment can be made to demonstrate their viability to lending institutions. SSI entrepreneurs also have problems in convincing banks of their managerial competence which is an important consideration for institutional lenders.

It is also reported that SSI inability to give security in the form of real estate, i.e. land or buildings is a problem in securing loan assistance. In Tanzania land has never been a major form of security, partly because the marketability of land is very limited owing to traditional restrictions on its transferability. Therefore, banks ask borrowers for guarantees by third parties, including public institutions like SIDO, which are not always able to stand for entrepreneurs they do not know. Expansion of guarantee facilities may help to resolve the problem.

Financing problems also partly arise from weaknesses on the part of bankers. In general, banks lack accessibility to potential borrowers not only in terms of lending but also in project identification, project formulation, and technical and management guidance, which can be even more crucial problems than lending itself. Another problem is that of capability and efficiency of bank staff, worsened by inadequacy of qualified manpower.

Where the industry owns modern equipment it is frequently faced by electric power cuts or voltage instability. For many places electricity is not available at all. Furthermore, few SSIs employ competent electricians to correctly wire and service equipment so that breakdowns or damage are common.

Risk and Return in Practice: Problems and Questions

1. In December 1995, Boise Cascade's stock had a beta of 0.95. The treasury bill rate at the time was 5.8%, and the treasury bond rate was 6.4%. The firm had debt outstanding of $ 1.7 billion and a market value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%.

a. Estimate the expected return on the stock for a short term investor in the company.

b. Estimate the expected return on the stock for a long term investor in the company.

c. Estimate the cost of equity for the company.

2. Boise Cascade also had debt outstanding of $ 1.7 billion and a market value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%.

a. Assuming that the current beta of 0.95 for the stock is a reasonable one, estimate the unlevered beta for the company.

b. How much of the risk in the company can be attributed to business risk and how much to financial leverage risk?

3. Biogen Inc., as biotechnology firm, had a beta of 1.70 in 1995. It had no debt outstanding at the end of that year.

a. Estimate the cost of equity for Biogen, if the treasury bond rate is 6.4%.

b. What effect will an increase in long term bond rates to 7.5% have on Biogen's cost of equity?

c. How much of Biogen's risk can be attributed to business risk?

4. Genting Berhad is a Malaysian conglomerate, with holding in plantations and tourist resorts. The beta estimated for the firm, relative to the Malaysian stock exchange, is 1.15, and the long term government borrowing rate in Malaysia is 11.5%.

a. Estimate the expected return on the stock.

b. If you were an international investor, what concerns, if any, would you have about using the beta estimated relative to the Malaysian Index? If you do, how would you modify the beta?

5. You have just done a regression of monthly stock returns of HeavyTech Inc., a manufacturer of heavy machinery, on monthly market returns over the last five years and come up with the following regression:

RHeavyTech = 0.5% + 1.2 RM

The variance of the stock is 50% and the variance of the market is 20%. The current T.Bill rate is 3% (It was 5% one year ago). The stock is currently selling for $50, down $4 over the last year, and has paid a dividend of $2 during the last year and expects to pay a dividend of $2.50 over the next year. The NYSE composite has gone down 8% over the last year, with a dividend yield of 3%. HeavyTech Inc. has a tax rate of 40%.

a. What is the expected return on HeavyTech over the next year?

b. What would you expect HeavyTech's price to be one year from today?

c. What would you have expected HeavyTech's stock returns to be over the last year?

d. What were the actual returns on HeavyTech over the last year?

e. HeavyTech has $100 million in equity and $ 50 million in debt. It plans to issue $50 million in new equity and retire $50 million in debt. Estimate the new beta.

6. Safecorp, which owns and operates grocery stores across the United States, currently has $50 million in debt and $100 million in equity outstanding. Its stock has a beta of 1.2. It is planning a leveraged buyout , where it will increase its debt/equity ratio of 8. If the tax rate is 40%, what will the beta of the equity in the firm be after the LBO?

7. Novell, which had a market value of equity of $2 billion and a beta of 1.50, announced that it was acquiring WordPerfect, which had a market value of equity of $ 1 billion, and a beta of 1.30. Neither firm had any debt in its financial structure at the time of the acquisition, and the corporate tax rate was 40%.

a. Estimate the beta for Novell after the acquisition, assuming that the entire acquisition was financed with equity.

b. Assume that Novell had to borrow the $ 1 billion to acquire WordPerfect. Estimate the beta after the acquisition.

8. You are analyzing the beta for Hewlett Packard and have broken down the company into four broad business groups, with market values and betas for each group.

Business GroupMarket Value of Equity

Beta

Mainframes $ 2.0 billion 1.10Personal Computers

$ 2.0 billion 1.50

Software $ 1.0 billion 2.00Printers $ 3.0 billion 1.00

a. Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the beta estimated by regressing past returns on HP stock against a market index. Why or Why not?

b. If the treasury bond rate is 7.5%, estimate the cost of equity for Hewlett Packard. Estimate the cost of equity for each division. Which cost of equity would you use to value the printer division?

c. Assume that HP divests itself of the mainframe business and pays the cash out as a dividend. Estimate the beta for HP after the divestiture. (HP had $ 1 billion in debt outstanding.)

9. The following table summarizes the percentage changes in operating income, percentage changes in revenue and betas for four pharmaceutical firms.

Firm % Change in Revenue% Change in Operating Income

Beta

PharmaCorp 27% 25% 1.00SynerCorp 25% 32% 1.15BioMed 23% 36% 1.30Safemed 21% 40% 1.40

a. Calculate the degree of operating leverage for each of these firms.

b. Use the operating leverage to explain why these firms have different betas.

10. A prominent beta estimation service reports the beta of Comcast Corporation, a major cable TV operator, to be 1.45. The service claims to use weekly returns on the stock over the prior five years and the NYSE composite as the market index to estimate betas. You replicate the regression using weekly returns over the same period and arrive at a beta estimate of 1.60. How would you reconcile the two estimates?

11. Battle Mountain is a mining company, which mines gold, silver and copper in mines in South America, Africa and Australia. The beta for the stock is estimated to be 0.30. Given the volatility in commodity prices, how would you explain the low beta?

12. You have collected returns on AnaDone Corporation (AD Corp.), a large diversified manufacturing firm, and the NYSE index for five years:

Year AD Corp NYSE 1981 10% 5% 1982 5% 15% 1983 -5% 8% 1984 20% 12% 1985 -5% -5%

a. Estimate the intercept (alpha) and slope (beta) of the regression.

b. If you bought stock in AD Corp. today how much would you expect to make as a return over the next year? [The six-month T.Bill rate is 6%]

c. Looking back over the last five years, how would you evaluate AD's performance relative to the market? (The riskfree rate during the period was also 6% on an annual basis)

d. Assume now that you are an undiversified investor and that you have all of your money invested in AD Corporation. What would be a good measure of the risk that you are taking on? How much of this risk would you be able to eliminate if you diversify?

e. AD is planning to sell off one of its divisions. The division under consideration has assets which comprise half of the book value of AD Corporation, and 20% of the market value. Its beta is twice the average beta for AD Corp (before divestment). What will the beta of AD Corporation be after divesting this division?

13. You run a regression of monthly returns of Mapco Inc, an oil and gas producing firm, on the S&P 500 index and come up with the following output for the period 1991 to 1995.

Intercept of the regression = 0.06%

X-coefficient of the regression = 0.46

Standard error of X-coefficient = 0.20

R squared = 5%

There are 20 million shares outstanding, and the current market price is $ 2. The firm has $ 20 million in debt outstanding. (The firm has a tax rate of 36%)

a. What would an investor in Mapco's stock require as a return, if the T.Bond rate is 6%?

b. What proportion of this firm's risk is diversifiable?

c. Assume now that Mapco has three divisions, of equal size (in market value terms). It plans to divest itself of one of the divisions for $ 20 million in cash and acquire another for $ 50 million (It will borrow $ 30 million to complete this acquisition). The division it is divesting is in a business line where the average unlevered beta is 0.20, and the division it is acquiring is in a business line where the average unlevered beta is 0.80. What will the beta of Mapco be after this acquisition?

14. You have just run a regression of monthly returns of American Airlines (AMR) against the S&P 500 over the last five years. You have misplaced some of the output and are trying to derive it from what you have.

a. You know the R squared of the regression is 0.36, and that your stock has a variance of 67%. The market variance is 12%. What is the beta of AMR?

b. You also remember that AMR was not a very good investment during the period of the regression and that it did worse than expected (after adjusting for risk) by 0.39 % a month for the five years of the regression. During this period, the average riskfree rate was 4.84%. What was the intercept on the regression?

c. You are comparing AMR Inc. to another firm which also has an R squared of 0.48. Will the two firms have the same beta? If not, why not?

15. You have run a regression of monthly returns on Amgen, a large biotechnology firm, against monthly returns on the S&P 500 index, and come up with the following output ñ

Rstock = 3.28% + 1.65 RMarket R2= 0.20

The current one-year treasury bill rate is 4.8% and the current thirty-year bond rate is 6.4%. The firm has 265 million shares outstanding, selling for $ 30 per share.

i. What is the expected return on this stock over the next year?

ii. Would your expected return estimate change if the purpose was to get a discount rate to analyze a thirty-year capital budgeting project?

iii. An analyst has estimated, correctly, that the stock did 51.10% better than expected, annually, during the period of the regression. Can you estimate the annualized riskfree rate that she used for her estimate?

iv. The firm has a debt/equity ratio of 3%, and faces a tax rate of 40%. It is planning to issue $2 billion in new debt and acquire a new business for that amount, with the same risk level as the firm's existing business. What will the beta be after the acquisition?

16. You have just run a regression of monthly returns on MAD Inc., a newspaper and magazine publisher, against returns on the S&P 500, and arrived at the following result ñ

RMAD = - 0.05% + 1.20 RS&P

The regression has an R-squared of 22%. The current T.Bill rate is 5.5% and the current T.Bond rate is 6.5%. The riskfree rate during the period of the regression was 6%.. Answer the following questions relating to the regression ñ

a. Based upon the intercept, you can conclude that the stock did

A. 0.05% worse than expected on a monthly basis, during the regression.

B. 0.05% better than expected on a monthly basis during the period of the regression

C. 1.25% better than expected on a monthly basis during the period of the regression.

D. 1.25% worse than expected on a monthly basis during the period of the regression.

E. None of the above. (1 point)

b. You now realize that MAD Inc went through a major restructuring at the end of last month (which was the last month of your regression), and made the following changes

o The firm sold off its magazine division, which had an unlevered beta of 0.6, for $ 20 million.

o It borrowed an additional $ 20 million, and bought back stock worth $ 40 million.

After the sale of the division and the share repurchase, MAD Inc. had $ 40 million in debt and $ 120 million in equity outstanding.

If the firm's tax rate is 40%, re-estimate the beta, after these changes.

17. Time Warner Inc., the entertainment conglomerate, has a beta of 1.61. Part of the reason for the high beta is the debt left over from the leveraged buyout of Time by Warner in 1989, which amounted to $10 billion in 1995. The market value of equity at Time Warner in 1995 was also $ 10 billion. The marginal tax rate was 40%.

a. Estimate the unlevered beta for Time Warner.

b. Estimate the effect of reducing the debt ratio by 10% each year for the next two years on the beta of the stock.

18. Chrysler, the automotive manufacturer, had a beta of 1.05 in 1995. It had $ 13 billion in debt outstanding in that year, and 355 million shares trading at $ 50 per share. The firm had a cash balance of $ 8 billion at the end of 1995. The marginal tax rate was 36%.

a. Estimate the unlevered beta of the firm.

b. Estimate the effect of paying out a special dividend of $ 5 billion on this unlevered beta.

c. Estimate the beta for Chrysler after the special dividend.

19. You are trying to estimate the beta of a private firm that manufactures home appliances. You have managed to obtain betas for publicly traded firms that also manufacture home appliances.

Firm Beta Debt MV of EquityBlack & Decker 1.40 $ 2,500 $ 3,000Fedders Corp. 1.20 $ 5 $ 200Maytag Corp. 1.20 $ 540 $ 2250National Presto 0.70 $ 8 $ 300Whirlpool 1.50 $ 2900 $ 4000

The private firm has a debt equity ratio of 25%, and faces a tax rate of 40%. The publicly traded firms all have marginal tax rates of 40%, as well.

a. Estimate the beta for the private firm.

b. What concerns, if any, would you have about using betas of comparable firms?

20. As the result of stockholder pressure, RJR Nabisco is considering spinning off its food division. You have been asked to estimate the beta for the division, and decide to do so by obtaining the beta of comparable publicly traded firms. The average beta of comparable publicly traded firms is 0.95, and the average debt/equity ratio of these firms is 35%. The division is expected to have a debt ratio of 25%. The marginal corporate tax rate is 36%.

a. What is the beta for the division?

b. Would it make any difference if you knew that RJR Nabisco had a much higher fixed cost structure than the comparable firms used here?

21. Southwestern Bell, a phone company, is considering expanding its operations into the media business. The beta for the company at the end of 1995 was 0.90, and the debt/equity ratio was 1. The media business is expected to be 30% of the overall firm value in 1999, and the average beta of comparable firms is 1.20; the average debt/equity ratio for these firms is 50%. The marginal corporate tax rate is 36%.

a. Estimate the beta for Southwestern Bell in 1999, assuming that it maintains its current debt/equity ratio.

b. Estimate the beta for Southwestern Bell in 1999, assuming that it decides to finance its media operations with a debt/equity ratio of 50%.

22. The chief financial officer of Adobe Systems, a growing software manufacturing firm, has approached you for some advice regarding the beta of his company. He subscribes to a service which estimates Adobe System's beta each year, and he has noticed that the beta estimates have gone down every year since 1991 - 2.35 in 1991 to 1.40 in 1995. He would like the answers to the following questions ñ

a. Is this decline in beta unusual for a growing firm?

b. Why would the beta decline over time?

c. Is the beta likely to keep decreasing over time?

23. You are analyzing Tiffany's, an upscale retailer, and find that the regression estimate of the firm's beta is 0.75; the standard error for the beta estimate is 0.50. You also note that the average unlevered beta of comparable specialty retailing firms is 1.15.

a. If Tiffany's has a debt/equity ratio of 20%, estimate the beta for the company based upon comparable firms. (The tax rate is 40%)

b. Estimate a range for the beta from the regression.

c. How would you reconcile the two estimates? Which one would you use in your analysis?

Measuring Investment Returns: Questions and Exercises

1. You have been given the following information on a project:

It has a 5-year lifetime The initial investment in the project will be $25 million, and the investment will be

depreciated straight line, down to a salvage value of $10 million at the end of the fifth year.

The revenues are expected to be $20 million next year and to grow 10% a year after that for the remaining 4 years.

The cost of goods sold, excluding depreciation, is expected to be 50% of revenues. The tax rate is 40%.

a. Estimate the pre-tax return on capital, by year and on average, for the project.

b. Estimate the after-tax return on capital, by year and on average, for the project.

c. If the firm faced a cost of capital of 12%, should it take this project.

2. Now assume that the facts in problem 1 remain unchanged except for the depreciation method, which is switched to an accelerated method with the following depreciation schedule:

Year% of Depreciable Asset

1 40%2 24%3 14.4%4 13.3%5 13.3%

Depreciable Asset = Initial Investment - Salvage Value

a. Estimate the pre-tax return on capital, by year and on average, for the project.

b. Estimate the after-tax return on capital, by year and on average, for the project.

c. If the firm faced a cost of capital of 12%, should it take this project?

3. Consider again the project described in problem 1 (assume that the depreciation reverts to straight line). Assume that 40% of the initial investment for the project will be financed with debt, with an annual interest rate of 10% and a balloon payment of the principal at the end of the fifth year.

a. Estimate the return on equity, by year and on average, for this project.

b. If the cost of equity is 15%, should the firm take this project?

4. Answer true or false to the following statements:

a. The return on equity for a project will always be higher than the return on capital on the same project.

b. If the return on capital is less than the cost of equity, the project should be rejected.

c. Projects with high financial leverage will have higher interest expenses and lower net income than projects with low financial leverage and thus end up with a lower return on equity.

d. Increasing the depreciation on an asset will increase the estimated return on capital and equity on the project.

e. The average return on equity on a project over its lifetime will increase if we switch from straight line to double declining balance depreciation.

5. Under what conditions will the return on equity on a project be equal to the internal rate of return, estimated from cashflows to equity investors, on the same project?

6. You are provided with the projected income statements for a project:

Year 1 2 3 4Revenues $ 10,000 $ 11,000 $12,000 $13,000- Cost of Goods Sold $ 4,000 $ 4,400 $ 4,800 $ 5,200 - Depreciation $ 4,000 $ 3,000 $ 2,000 $ 1,000 = EBIT $ 2,000 $ 3,600 $ 5,200 $ 6,800

The tax rate is 40%. The project required an initial investment of $15,000 and an additional investment of

$2,000 at the end of year 2. The working capital is anticipated to be 10% of revenues, and the working capital

investment has to be made at the beginning of each period.

a. Estimate the free cash flow to the firm for each of the 4 years.

b. Estimate the payback period for investors in the firm.

c. Estimate the net present value to investors in the firm, if the cost of capital is 12%. Would you accept the project?

d. Estimate the internal rate of return to investors in the firm. Would you accept the project?

7. Consider the project described in problem 6. Assume that the firm plans to finance 40% of its net capital expenditure and working capital needs with debt. The interest rate on debt is 10%.

a. Estimate the free cash flow to equity for each of the 4 years.

b. Estimate the payback period for equity investors in the firm.

c. Estimate the net present value to equity investors if the cost of equity is 16%. Would you accept the project?

d. Estimate the internal rate of return to equity investors in the firm. Would you accept the project?

8. You are provided with the following cash flows on a project:

YearCash Flow to Firm

0 - 10,000,0001 $ 4,000,0002 $ 5,000,0003 $ 6,000,000

Plot the net present value profile for this project. What is the internal rate of return? If this firm had a cost of capital of 10% and a cost of equity of 15%, would you accept this project?

9. You have estimated the following cash flows on a project:

YearCashflow to Equity

0 -$ 4,750,0001 $4,000,0002 $ 4,000,0003 - $3,000,000

Plot the net present value profile for this project. What is the internal rate of return? If the cost of equity is 16%, would you accept this project?

10. Estimate the modified internal rate of return for the project described in problem 8. Does it change your decision on accepting this project?

11. You are analyzing two mutually exclusive projects with the following cash flows:

Year A B 0 -$4,000,000 -$4,000,000 1 $2,000,000 $1,000,000 2 $1,500,000 $1,500,000 3 $ 1,250,000 $1,700,000 4 $1,000,000 $2,400,000

a. Estimate the net present value of each project, assuming a cost of capital of 10%. Which is the better project?

b. Estimate the internal rate of return for each project. Which is the better project?

c. What reinvestment rate assumptions are made by each of these rules? Can you show the effect on future cash flows of these assumptions?

d. What is the modified internal rate of return on each of these projects?

12. You have a project that does not require an initial investment but has its expenses spread over the life of the project. Can the IRR be estimated for this project? Why or why not?

13. Businesses with severe capital rationing constraints should use IRR more than NPV. Do you agree? Explain.

14. You have to pick between three mutually exclusive projects with the following cash flows to the firm:

Year Project A Project B Project C0 -$10,000 $ 5,000 -$15,0001 $ 8,000 $ 5,000 $ 10,0002 $ 7,000 -$8,000 $10,000

The cost of capital is 12%.

a. Which project would you pick using the net present value rule?

b. Which project would you pick using the internal rate of return rule?

c. How would you explain the differences between the two rules? Which one would you rely on to make your choice?

15. You are analyzing an investment decision, in which you will have to make an initial investment of $10 million and you will be generating annual cash flows to the firm of $2 million every year, growing at 5% a year, forever.

a. Estimate the NPV of this project, if the cost of capital is 10%.

b. Estimate the IRR of this project.

16. You are analyzing a project with a 30-year lifetime, with the following characteristics:

The project will require an initial investment of $20 million and additional investments of $ 5 million in year 10 and $ 5 million in year 20.

The project will generate earnings before interest and taxes of $3 million each year. (The tax rate is 40%.)

The depreciation will amount to $500,000 each year, and the salvage value of the equipment will be equal to the remaining book value at the end of year 30.

The cost of capital is 12.5%.

a. Estimate the net present value of this project.

b. Estimate the internal rate of return on this project. What might be some of the problems in estimating the IRR for this project?

17. You are trying to estimate the NPV of a 3-year project, where the discount rate is expected to change over time.

YearCash Flow to Firm

Discount Rate

0 -$15,000 9.5% 1 $5,000 10.5% 2 $ 5,000 11.5% 3 $ 10,000 12.5%

a. Estimate the NPV of this project. Would you take this project?

b. Estimate the IRR of this project. How would you use the IRR to decide whether to take this project or not?

18. Barring the case of multiple internal rates of return, is it possible for the net present value of a project to be positive, while the internal rate of return is less than the discount rate. Explain.

19. You are helping a manufacturing firm decide whether it should invest in a new plant. The initial investment is expected to be $ 50 million, and the plant is expected to generate after-tax cashflows of $ 5 million a year for the next 20 years. There will be an additional investment of $ 20 million needed to upgrade the plant in 10 years. If the discount rate is 10%,

a. Estimate the Net Present Value of the project.

b. Prepare a Net Present Value Profile for this project.

c. Estimate the Internal Rate of Return for this project. Is there any aspect of the cashflows that may prove to be a problem for calculating IRR?

20. You have been asked to analyze a project, where the analyst has estimated the return on capital to be 37% over the ten-year lifetime of the project. While the cost of capital is only 12%, you have concerns about using the return on capital as an investment decision rule. Would it make a difference if you knew that the project was employing an accelerated depreciation method to compute depreciation? Why?

21. Accounting rates of return are based upon accounting income and book value of investment, whereas internal rates of return are based upon cashflows and take into account the time value of money. Under what conditions will the two approaches give you similar estimates?

22. You have acquired new equipment for a project, costing $ 15 million. The equipment is expected to have a salvage value of $ 3 million and a depreciable life of 10 years. The cost of capital is 12%, and the firm faces a tax rate of 40%.

a. Estimate the present value and the nominal value of the tax benefits from depreciation, assuming that you use straight line depreciation.

b. Estimate the present value and the nominal value of the tax benefits from depreciation, assuming that you use double declining balance depreciation.

c. Why does double declining balance depreciation yield a higher present value?

23. You are analyzing the depreciation tax benefits from acquiring an asset that cost $2.5 million and has a salvage value of $0.5 million. The asset is classified as an asset with a 5-year depreciable life in the ACRS system. Using the depreciation rates provided in the ACRS table:

a. Estimate the depreciation tax benefits each year on this asset, assuming that the tax rate is 40%.

b. Estimate the present value of these tax benefits, assuming a cost of capital of 10%.

c. If you could expense this asset instead of using the ACRS rates, how much would you gain in present value terms from tax benefits?

24. In both the examples above, there is an estimated salvage value. Assuming that you have to pay capital gains taxes at 20% on any excess of salvage value over book value, would you gain or lose by depreciating the assets down to zero and paying the capital gains taxes. Illustrate using straight line depreciation on problem 1 and ACRS depreciation in problem 2.

25. You have just acquired equipment for $ 10 million, with a depreciable life of 5 years and no salvage value. You must decide whether you should be using straight line or double declining balance method in estimating taxes and cash flows. Your tax rate is expected to increase over the 5 years ñ

Year Tax Rate 1 20%2 25%3 30%4 35%5 40%

a. Which depreciation method provides the larger nominal tax benefits?

b. Which depreciation method provides the larger present value in tax benefits, assuming your cost of capital is 12%?

26. You are analyzing a project with a life of 5 years, which requires an initial investment in equipment and machinery of $10 million. The equipment is expected to have a 5-year lifetime and no salvage value and to be depreciated straight line. The project is expected to generate revenues of $ 5 million each year for the 5 years and have operating expenses (not including depreciation) amounting to 30% of revenues. The tax rate is 40%, and the cost of capital is 11%.

a. Estimate the after-tax operating cash flow each year on this project.

b. Estimate the net present value for this project.

c. How much of the net present value can be attributed to the tax benefits accruing from depreciation?

d. Assume that the firm that takes this project is losing money currently, and expects to continue losing money for the first 3 years. Estimate the net present value of this project.

27. You are considering a capital budgeting proposal to make 'glow-in-the-dark' pacifiers for anxious first-time parents. You estimate that the equipment to make the pacifiers would cost you $50,000 (which you can depreciate straight line over the lifetime of the project, which is 10 years) and that you can sell 15,000 units a year at $2 a unit. The cost of making each pacifier would be $0.80, and the tax rate you would face would be 40%. You also estimate that you will need to maintain an inventory at 25% of revenues for the period of the project and that you can salvage 80% of this working capital at the termination of the project. Finally, you will be setting up the equipment in your garage, which means you will have to pay $2000 a year to have your car garaged at a nearby private facility (assume that you can deduct this cost for tax purposes). To estimate the discount rate for this project, you find that there are comparable firms being traded on the financial markets with the following betas:

Company Debt-Equity ratioTax rateBeta

Nuk-Nuk 0.50 0.401.3

Gerber1.000.50 1.5

You expect to finance this project entirely with equity, and the current T.Bond rate is 11.5%.

(a) What is the appropriate discount rate to use for this project?

(b) What is the after-tax operating cashflow each year for the lifetime of the project?

(c) What is the NPV of this project?

28. You are a financial analyst for a company that is considering a new project. If the project is accepted, it will use 40% of a storage facility that the company already owns but currently does not use fully. The project is expected to last 10 years, and the discount rate is 10%. You research the possibilities and find that the entire storage facility can be sold for $100,000 and a smaller facility acquired for $ 40,000. The book value of the existing facility is $60,000, and both the existing and the new facilities (if it is acquired) would be depreciated straight line over 10 years. The ordinary tax rate is 40%, and the capital gains rate is 25%. What is the opportunity cost, if any, of using the storage capacity?

29. You have been observing the progressive gentrification of you city with interest. You realize that the time is ripe for you to open and run an aerobic exercise center. You find an abandoned warehouse which will meet your needs and rents for $48,000/ year. You estimate that it will initially cost $50,000 to renovate the place and buy Nautilius equipment for the center (there will be no salvage and the entire initial cost is depreciable). Your market research indicates that you can expect to get 500 members, each paying $500/year. You have also found five instructors you can hire for $24000 a year each. Your tax rate, if you start making profits, will be 40%, and you choose to use straight line depreciation on your initial investment. If your cost of capital is 15% and you expect to retire to the Bahamas in 10 years, answer the following questions:

a. Estimate the annual after tax cash flows on this project.

b. Estimate the net present value and internal rate of return for this investment. Would you take it?

30. Brooks Brothers is thinking of investing in a new line of ìpunk rockerî clothes for the new executive. You have been hired to evaluate the project. You find that, if the project is accepted, you could use an abandoned warehouse already owned by Brooks Brothers with a book value of $500,000. Your superior had been planning to rent this warehouse out to another firm for $100,000 a year. If your tax rate is 40%, your discount rate is 15%, your project lifetime is 10 years and you use straight line depreciation, what is the opportunity cost of this investment?

31. You are graduating in June and would like to start your own business manufacturing wine coolers. You collect the following information on the initial costs:

Cost of Plant and Equipment = $ 500000

Licensing and Legal Costs = $ 50000

You can claim an investment tax credit of 10% on plant and equipment. You also have been left a tidy inheritance that will cover the initial cost, and your estimated opportunity cost is 10%.

You estimate that you can sell 1 million bottles a year at $1 a bottle. You estimate your costs as follows:

Variable costs/bottle = 50 cents

Fixed Costs/ year = $ 200000

Adding up state, local, and federal taxes, you note that you will be in the 50% tax bracket. To be conservative, you assume that you will terminate the business in 5 years and that you will get nothing from the plant and equipment as salvage (you also use straight line depreciation). As a final consideration, you note that starting this business will mean that you will not be able to take the investment banking job you have been offered (which offered $ 75000 a year for the next 5 years). Should you take on the project?

32. You are an expert at working with PCs and are considering setting up a software development business. To set up the enterprise, you anticipate that you will need to acquire computer hardware costing $ 100,000 (the lifetime of this hardware is 5 years for depreciation purposes, and straight line depreciation will be used). In addition, you will have to rent an office for $50000 a year. You estimate that you will need to hire five software specialists at $ 50000 a year to work on the software and that your marketing and selling costs will be $ 100000 a year. You expect to price the software you produce at $100 per unit and to sell 6000 units in the first year. The actual cost of materials used to produce each unit is $ 20. The number of units sold is expected to increase 10% a year for the remaining 4 years, and the revenues and costs are expected to increase at 3% a year, reflecting inflation. The actual cost of materials used to produce each unit is $ 20, and you will need to maintain working capital at 10% of revenues (assume that the working capital investment is made at the beginning of each year). Your tax rate will be 40%, and the cost of capital is 12%.

a. Estimate the cash flows each year on this project.

b. Should you accept the project?

33. You are an analyst for a sporting goods corporation that is considering a new project that will take advantage of excess capacity in an existing plant. The plant has a capacity to produce 50000 tennis racquets, but only 25,000 are being produced currently though sales of the rackets are increasing 10% a year. You want to use some of the remaining capacity to manufacture 20,000 squash rackets each year for the next 10 years (which will use up 40% of the total capacity), and this market is assumed to be stable (no growth). An average tennis racquet sells for $100 and costs $40 to make. The tax rate for the corporation is 40%, and the discount rate is 10%. Is there an opportunity cost involved? If so, how much is it?

34. You are examining the viability of a capital investment that your firm is interested in. The project will require an initial investment of $500,000 and the projected revenues are $400,000 a year for 5 years. The projected cost-of-goods-sold is 40% of revenues and the tax rate is 40%. The initial investment is primarily in plant and equipment and can be depreciated straight-line over 5 years (the salvage value is zero). The project makes use of other resources that your firm already owns:

(a) Two employees of the firm, each with a salary of $40,000 a year, who are currently employed by another division will be transferred to this project. The other division has no alternative use

for them, but they are covered by a union contract which will prevent them from being fired for 3 years (during which they would be paid their current salary).

(b) The project will use excess capacity in the current packaging plant. While this excess capacity has no alternative use now, it is estimated that the firm will have to invest $ 250,000 in a new packaging plant in year 4 as a consequence of this project using up excess capacity (instead of year 8 as originally planned).

(c) The project will use a van currently owned by the firm. While the van is not currently being used, it can be rented out for $ 3000 a year for 5 years. The book value of the van is $10,000 and it is being depreciated straight line (with 5 years remaining for depreciation).

The discount rate to be used for this project is 10%.

a. What (if any) is the opportunity cost associated with using the two employees from another division?

b. What, if any, is the opportunity cost associated with the use of excess capacity of the packaging plant?

c. What, if any, is the opportunity cost associated with the use of the van ?

d. What is the after-tax operating cashflow each year on this project?

e. What is the net present value of this project?

35. You have been hired as a capital budgeting analyst by a sporting goods firm that manufactures athletic shoes and has captured 10% of the overall shoe market (the total market is worth $100 million a year). The fixed costs associated with manufacturing these shoes is $2 million a year, and variable costs are 40% of revenues. The company's tax rate is 40%.

The firm believes that it can increase its market share to 20% by investing $10 million in a new distribution system (which can be depreciated over the system's life of 10 years to a salvage value of zero) and spending $1 million a year in additional advertising. The company proposes to continue to maintain working capital at 10% of annual revenues. The discount rate to be used for this project is 8%.

a. What is the initial investment for this project?

b. What is the annual operating cashflow from this project?

c. What is the NPV of this project?

36. Your company is considering producing a new product. You have a production facility that is currently used to only 50% of capacity, and you plan to use some of the excess capacity for the new product. The production facility cost $50 million 5 years ago when it was built and is being

depreciated straight line over 25 years (in real dollars, assume that this cost will stay constant over time).

Product lineCapacity used currently

Growth rate/year

Revenues currently

Fixed Costs/Yr

Variable Costs/yr

Old product 50% 5%/year 100 mil 25 mil 50 mil/yr New product 30% 10%/year 80 mil 20 mil 44 mil/yr

The new product has a life of 10 years, the tax rate is 40%, and the appropriate discount rate (real) is 10%.

a. If you take on this project, when would you run out of capacity?

b. When you run out of capacity, what would you lose if you chose to cut back production (in present value after-tax dollars)? (You have to decide which product you are going to cut back production on.)

c. What would the opportunity cost to be assigned to this new product be if you chose to build a new facility when you run out of capacity instead of cutting back on production?

37. You run a mail-order firm, selling upscale clothing. You are considering replacing your manual ordering system with a computerized system to make your operations more efficient and to increase sales. (All the cash flows given below are in real terms.)

The computerized system will cost $10 million to install, and $500,000 to operate each year. It will replace a manual order system that costs $1.5 million to operate each year.

The system is expected to last 10 years, and have no salvage value at the end of the period.

The computerized system is expected to increase annual revenues from $5 million to $8 million for the next 10 years.

The costs of goods sold is expected to remain at 50% of revenues. The tax rate is 40%. As a result of the computerized system, the firm will be able to cut its inventory from

50% of revenues to 25% of revenues immediately. There is no change expected in the other working capital components.

The real discount rate is 8%.

a. What is your expected cash flow at time=0?

b. What is the expected incremental annual cash flow from computerizing the system?

c. What is the net present value of this project

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The Investment Decision: Measuring Hurdle Rates

   Overheads Download as pdf file

Data Sets

1. Interest Coverage Ratios, Ratings and Default Spreads

2. Historical Returns on Stocks, Bonds and Bills: United States

3. Country Ratings, Country Spreads and Equity Premiums

4. Implied Premiums for the United States: 1960 - Present

5. Unlevered and Levered Betas by Industry Group: United States

6. Historical Earnings Changes per Year: S&P 500

Spreadsheets

1. Estimating Implied Equity Premium in a Market 2. Estimating CAPM parameters for a firm 3. Unlevering and Levering Betas 4. Estimating Synthetic rating for a firm 5. Cost of Capital Estimation

Problems and SolutionsProblems on Risk, Return and Hurdle Rates (Download solutions in pdf file)

Derivations, In-Practice Questions and Discussion

Models of Risk and ReturnApplying Models of Risk and Return

Readings

1. Operating Risk as a Measure of Risk 2. Market Risk and Time Horizon 3. Investors must recall risk 4. Risk Premium in Emerging Markets 5. Classic Rule of Risk Premium under Attack 6. Are risk premiums too low? (Greenspan testimony)

Live Case StudyAnalyzing a Firm's StockholdersDeveloping a Firm's Risk Profile

The Investment Decision: Measuring Returns on Investments

   Overheads Download as pdf file

Data Sets

1. Operating Income and Cash Flows: By Sector 2. EVA and Equity EVA: By Sector 3. Variances in Firm Value: By Sector

Spreadsheets 1. Estimating Cash Flows to Firm and Return Diagnostics on Project

2. Estimating Cash Flows to Equity and Return Diagnostics on Project

3. Present Value Calculator 4. Valuing the Option to Delay 5. Valuing the Option to Expand 6. Valuing the Option to Abandon

Problems and SolutionsProblems on Measuring Investment Returns (Download solutions in pdf file)

Derivations, In-Practice Questions and Discussion

Measurement of Project ReturnsEstimating Side Costs and Benefits

Readings

1. Measuring Earnings 2. The Content of an Annual Report 3. EVA as elixir 4. Synergy in Mergers

Live Case Study Measuring a Firm's Investment Returns

The Financing Decision

   Overheads Download as pdf file

Data Sets

1. Debt Ratios and Fundamentals 2. Book and Market Debt Ratios By Industry 3. Cross Sectional Debt Ratio Regression for the US 4. Macro Economic Data: Historical 5. Sensitivity to Macro-economic Variables: By

Industry

Spreadsheets

1. Optimal Capital Structure with WACC (Operating Income held constant)

2. Optimal Capital Stucture with WACC (Operating Income allowed to vary)

3. Optimal Capital Structure with APV

Problems and Solutions

Problems on Capital Structure: The Choices (Download solutions in pdf fileProblems on Capital Structure: The Optimal Mix (Download solutions in pdf file)Capital Structure: Moving to the Optimal (Download solutions in pdf file)

Derivations, In-Practice Questions and Discussion

Capital Strucure: The ChoicesCapital Structure: The Optimal MixCapital Structure: Moving to the Optimal

Readings

1. Stock Buybacks are not always good news 2. Catastrophe Bonds 3. Mismatching Financing: The Indonesian Experience

Live Case StudyThe Financing DecisionAnalyzing a Firm's Optimal Debt RatioDeveloping a Firm's Financial Details