Capital Investment Problem Set You are analyzing the project with a life of five years, which requires an initial investment in equipment and…

Capital Investment Problem Set

  1. You are analyzing the project with a life of five years, which requires an initial investment in equipment and machinery of $10 million. The equipment is expected to have a five 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 five 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.    What is the after-tax income each year on this project.

b.    What is the after-tax operating cash flow each year on this project

c.    Assume that the firm that takes this project is losing money currently and expects to continue losing at least as much as this project makes over the next three years. Estimate the minimum after-tax operating income and cash flows on this project.

d.    Should the firm mentioned in (c) invest in this project?

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

Year                Project A                    Project B                    Project C

     0                     -$10,000                     $5,000                        -$15,000

     1                         8,000                      5,000                           10,000

     2                         7,000                      -8,000                           10,000

The cost of capital is 12%.

a.             Which project would you pick using the NPV?

b.             Which project would you pick using IRR?

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

3.    Barring the case of multiple internal rates of return, is it possible for the NPV of a project to be positive, while the IRR is less than the discount rate?? Explain and give an example.

4.    You are contemplating customizing a wireless tablet computer to be bundled with application software and sold into a specific vertical market. This bundling and customization involves some minor hardware modifications but more significant software development.  To accomplish the software modifications needed you can either do the work yourself (‘in house’) or license the software from another company that has done similar work for another brand of tablet. Doing it in house will take longer to get to market but the software will be more robust and likely will result in higher sales.  Here is a summary of the sales of the two alternatives:

In house         License

Year 1             250,000          1,000,000

Year 2             3,000,000       1,500,000

Year 3             3,500,000       2,500,000

Year 4             2,200,000       2,000,000

Year 5             1,400,000       1,200,000                              

Year 6             700,000           500,000

Year 7                         0                     0

The license fee will be 5% of sales (treat this like an R&D expense on the income statement) but there are no other incremental development expenses, initial royalty payments, or investments. 

The in house option will require a $500,000 initial investment in development equipment which can be depreciated over a five year useful life.  This option will also require engineering expenses of $300,000 incurred and paid in year 1.

Under either alternative, cost of goods sold will be 40% of sales, and Sales/G&A expenses will be 15% of sales. Accounts Receivable and Inventory will have to be funded equal to 20% of the projected sales of the following year. The marginal tax rate is 40% and the cost of capital is 20%.

a.    What are the free cash flows of this project for the license alternative?

b.    What are the free cash flows of this project if internally developed?

c.    Would you license or develop internally? Why?

d.    Approximately what is the highest royalty rate you would pay? Explain.

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