1. OpenSeas, Inc. is evaluating the purchase of a new cruise ship. The ship could cost $499 million, but would operate for 2020 years. OpenSeas expects annual cash flows from operating the ship to be $ 68.7 million  (at the end of each  year) and its cost of capital is 11.7 %11.7%
2. Prepare an NPV profile of the purchase using discount rates of 2.0% , 11.5% and 17.0%.
3. Identify the IRR on a graph.
4. Is the purchase attractive based on these  estimates?
5. How far off could  OpenSeas’ cost of capital estimate be before your purchase decision would  change? (NOTE: Subtract the discount rate from the actual IRR. Use Excel to compute the actual  IRR.)

2. You have been offered a very  long-term investment opportunity to increase your money one hundredfold. You can invest $ 1,100 today and expect to receive $ 110,000 in 40 years. Your cost of capital for this  (very risky) opportunity is 23%.

What does the IRR rule say about whether the investment should be  undertaken? What about the NPV rule? Do they  agree?

What is the IRR ?

3. You own a coal mining company and are considering opening a new mine. The mine itself will cost $118 million to open. If this money is spent  immediately, the mine will generate $21 million for the next 10 years. After  that, the coal will run out and the site must be cleaned and maintained at environmental standards. The cleaning and maintenance are expected to cost $1.7 million per year in perpetuity. What does the IRR rule say about whether you should accept this  opportunity?

( Hint: Consider the number of sign changes in the cash flows. )

If the cost of capital is 8.4% , what does the NPV rule  say?

What does the IRR rule say about whether you should accept this  opportunity?  (Select the best choice  below.)

A.

Accept the opportunity because the IRR is greater than the cost of capital.

B.

There are two  IRRs, so you cannot use the IRR as a criterion for accepting the opportunity.

C.

Reject the opportunity because the IRR is lower than the

8.4 % cost of capital.

D.

The IRR is 11.06% , so accept the opportunity.

4. Your firm has been hired to develop new software for the  university’s class registration system. Under the  contract, you will receive

$497,000 as an upfront payment. You expect the development costs to be $440,000 per year for the next 33 years. Once the new system is in  place, you will receive a final payment of $863,000 from the university 44 years from now.

1. What are the IRRs of this  opportunity?  (Hint: Build an Excel model which tests the NPV at  1% intervals from  1% to  40%. Then zero in on the rates at which the NPV changes  signs.)
2. If your cost of capital is 10% , is the opportunity  attractive?

Suppose you are able to renegotiate the terms of the contract so that your final payment in year 4

will be $1.2 million.

1. What is the IRR of the opportunity  now?
2. Is it attractive at the new  terms?

5. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop. The sign will cost $10,000 and will be posted for one year. You expect that it will generate additional revenue of $1,500 a month. What is the payback  period? (in months)

6. You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $9.7 million. Investment A will generate $1.88 million per year  (starting at the end of the first  year) in perpetuity. Investment B will generate $1.46 million at the end of the first  year, and its revenues will grow at 2.7% per year for every year after that.
7. Which investment has the higher  IRR?
8. Which investment has the higher NPV when the cost of capital is

7.4% ?

1. In this  case, for what values of the cost of capital does picking the higher IRR give the correct answer as to which investment is the best  opportunity?

7. You work for an outdoor play structure manufacturing company and are trying to decide between the following two  projects:

You can undertake only one project. If your cost of capital is 8% ,

use the incremental IRR rule to make the correct decision.

The incremental IRR is %.

8. Facebook is considering two proposals to overhaul its network infrastructure. They have received two bids. The first bid from Huawei will require a $22 million upfront investment and will generate $20

million in savings for Facebook each year for the next 3 years. The second bid from Cisco requires a $89 million upfront investment and will generate $60 million in savings each year for the next 3

years.

1. What is the IRR for Facebook associated with each  bid?
2. If the cost of capital for each investment is 16% , what is the net present value (NPV ) for Facebook of each  bid?

Suppose Cisco modifies its bid by offering a lease contract instead. Under the terms of the  lease, Facebook will pay $28 million  upfront, and

$35 million per year for the next 3 years.  Facebook’s savings will be the same as with  Cisco’s original bid.

1. Including its  savings, what are  Facebook’s net cash flow under the lease  contract? What is the IRR of the Cisco bid  now?
2. Is this new bid a better deal for Facebook than  Cisco’s original  bid? Explain.

9. You own a car dealership and are trying to decide how to configure the showroom floor. The floor has 2000 square feet of usable space. You have hired an analyst and asked her to estimate the NPV of putting a particular model on the floor and how much space each model  requires:

In  addition, the showroom also requires office space. The analyst has estimated that office space generates a NPV of $14 per square foot. What models should be displayed on the floor and how many square feet should be devoted to office  space?

Complete the PI table  below: (Round to two decimal  places.)

10. Pisa  Pizza, a seller of frozen  pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $15

million per year. While many of these sales will be to new  customers, Pisa Pizza estimates that 31% will come from customers who switch to the  new, healthier pizza instead of buying the original version.

1. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new  pizza?
2. Suppose that 45% of the customers who will switch from Pisa  Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this  case?

11. Home Builder  Supply, a retailer in the home improvement  industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this  store, which currently has an abandoned warehouse located on it. Last  month, the marketing department spent $14,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the proposed new retail  store?
12. The cost of the land where the store will be located.
13. The cost of demolishing the abandoned warehouse and clearing the lot.
14. The loss of sales in the existing retail  outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead.
15. The $14,000 in market research spent to evaluate customer demand.
16. Construction costs for the new store.
17. The value of the land if sold. There is currently an offer of $14,000

from an interested buyer.

1. Interest expense on the debt borrowed to pay the construction costs.

14. One year  ago, your company purchased a machine used in manufacturing for $105,000. You have learned that a new machine is available that offers many  advantages; you can purchase it for $170,000

today. It will be depreciated on a  straight-line basis over ten  years, after which it has no salvage value. You expect that the new machine will contribute EBITDA  (earnings before  interest, taxes,  depreciation, and  amortization) of $35,000 per year for the next ten years. The current machine is expected to produce EBITDA of $22,000 per year. The current machine is being depreciated on a  straight-line basis over a useful life of 11  years, after which it will have no salvage  value, so depreciation expense for the current machine is $9,545 per year. All other expenses of the two machines are identical. The market value today of the current machine is $50,000. Your  company’s tax rate is 35%, and the opportunity cost of capital for this type of equipment is

12%.

Is it profitable to replace the  year-old machine?

The NPV of the replacement is $.

​

15. Bay Properties is considering starting a commercial real estate division. It has prepared the following  four-year forecast of free cash flows for this  division:

Assume cash flows after year 4 will grow at 1% per  year, forever. If the cost of capital for this division is 11% , what is the continuation value in year 4 for cash flows after year  4? What is the value today of this  division?

What is the continuation value in year 4 for cash flows after year  4?

16. Your firm would like to evaluate a proposed new operating division. You have forecasted cash flows for this division for the next five  years and have estimated that the cost of capital is 13%. You would like to estimate a continuation value. You have made the following forecasts for the last year of your  five-year forecasting horizon  (in millions of  dollars):

Note: Assume that all firms  (including yours) have no debt.

1. You forecast that future free cash flows after year 5 will grow at 2% per  year, forever. Estimate the continuation value in year  5, using the perpetuity with growth formula.
2. You have identified several firms in the same industry as your operating division. The average  P/E ratio for these firms is 26.

Estimate the continuation value assuming the  P/E ratio for your division in year 5 will be the same as the average  P/E ratio for the comparable firms today.

2. The average  market/book ratio for the comparable firms is 2.3.

Estimate the continuation value using the  market/book ratio.

17. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 11.7% to evaluate this project. Based on extensive  research, it has prepared the following incremental free cash flow projections  (in millions of  dollars):

1. For this  base-case scenario, what is the NPV of the plant to manufacture lightweight  trucks?
2. Based on input from the marketing  department, Bauer is uncertain about its revenue forecast. In  particular, management would like to examine the sensitivity of the NPV to the revenue assumptions. What is the NPV of this project if revenues are 8% higher than  forecast? What is the NPV if revenues are 8% lower than  forecast?
3. Rather than assuming that cash flows for this project are  constant, management would like to explore the sensitivity of its analysis to possible growth in revenues and operating expenses.  Specifically, management would like to assume that  revenues, manufacturing  expenses, and marketing expenses are as given in the table for year 1 and grow by 3% per year every year starting in year 2. Management also plans to assume that the initial capital expenditures  (and therefore  depreciation), additions to working  capital, and continuation value remain as initially specified in the table. What is the NPV of this project under these alternative  assumptions? How does the NPV change if the revenues and operating expenses grow by 6% per year rather than by 3%?
4. To examine the sensitivity of this project to the discount  rate, management would like to compute the NPV for different discount rates. Create a  graph, with the discount rate on the x -axis and the NPV on the

y -axis, for discount rates ranging from 5% to 30%.

For what ranges of discount rates does the project have a positive  NPV?