Your start-up company has negotiated a contract to provide a database installation for a manufacturing company in Poland. That firm has agreed to pay you 100,000 CAD in three-month’s time….
OpenSeas, Inc. is evaluating the purchase of a new cruise ship
- 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%
- Prepare an NPV profile of the purchase using discount rates of 2.0% , 11.5% and 17.0%.
- Identify the IRR on a graph.
- Is the purchase attractive based on these estimates?
- 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 ?
- 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.)
Accept the opportunity because the IRR is greater than the cost of capital.
There are two IRRs, so you cannot use the IRR as a criterion for accepting the opportunity.
Reject the opportunity because the IRR is lower than the
8.4 % cost of capital.
The IRR is 11.06% , so accept the opportunity.
- 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.
- 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.)
- 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.
- What is the IRR of the opportunity now?
- Is it attractive at the new terms?
- 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)
- 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 $1.46 million at the end of the first year, and its revenues will grow at 2.7% per year for every year after that.
- Which investment has the higher IRR?
- Which investment has the higher NPV when the cost of capital is
- In this case, for what values of the cost of capital does picking the higher IRR give the correct answer as to which investment is the best opportunity?
- You work for an outdoor play structure manufacturing company and are trying to decide between the following two projects:
|Year-End Cash Flows ($ thousands)|
|Playhouse (minor project)||-26||20||21||36.2 %|
|Fort (major project)||-79||39||50||8.0 %|
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 %.
- 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
- What is the IRR for Facebook associated with each bid?
- 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.
- Including its savings, what are Facebook’s net cash flow under the lease contract? What is the IRR of the Cisco bid now?
- Is this new bid a better deal for Facebook than Cisco’s original bid? Explain.
- 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:
|Model||NPV||Space Requirement (sq. ft.)|
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.)
|Model||NPV||Space Requirement (sq. ft.)||PI|
- 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.
- Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza?
- 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?
- 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?
- The cost of the land where the store will be located.
- The cost of demolishing the abandoned warehouse and clearing the lot.
- 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.
- The $14,000 in market research spent to evaluate customer demand.
- Construction costs for the new store.
- The value of the land if sold. There is currently an offer of $14,000
from an interested buyer.
- Interest expense on the debt borrowed to pay the construction costs.
- 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
Is it profitable to replace the year-old machine?
The NPV of the replacement is $.
- 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:
|Year 1||Year 2||Year 3||Year 4|
|Free cash flow||$102,000||$14,000||$77,000||$245,000|
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?
- 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):
|Free cash flows||
|Book value of equity||276.7|
Note: Assume that all firms (including yours) have no debt.
- 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.
- 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.
- The average market/book ratio for the comparable firms is 2.3.
Estimate the continuation value using the market/book ratio.
- 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):
- For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks?
- 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?
- 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%?
- 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?