FNCE 3010 (Durham) HW 7 capital budgeting 2

1. In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of over $40,000, the Cayenne goes from zero to 62 mph in 9.7 seconds. Porsches decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high prots. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo, which goes from zero to 62 mph in 5.6 seconds and has a top speed of 165 mph. The price tag for the Cayenne Turbo? Almost $100,000! Some analysts questioned Porsches entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsches reputation as a maker of high-performance automobiles. (a) In evaluating the Cayenne, would you consider the possible damage to Porsches reputation to be erosion? (b) Porsche was one of the last manufacturers to enter the sports-utility vehicle market. Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market? (c) In evaluating the Cayenne, what do you think Porsche needs to assume regarding the substantial prot margins that exist in this market? Is it likely they will decline as the market becomes more competitive, or will Porsche be able to maintain the prot margin because of its image and the performance of the Cayenne? Solution: (a) The damage to Porsches reputation is denitely a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines. (b) One company may be able to produce at lower incremental cost or market better. Perhaps Porsche has technology not available to other companies. They may also be taking advantage of their brand image. It is also possible that Porsche made a mistake by entering the market. (c) Porsche should recognize that the outsized prots could dwindle as more products comes to market and competition becomes more intense.

2. Parker & Stone, Inc., is looking at setting up a new manufacturing plant in South Park to produce garden tools. The company bought some land six years ago for $5 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent these facilities from a competitor instead. If the land were sold today, the company would net $5.4 million. The company wants to build its new manufacturing plant on this land; the plant will cost $10.4 million to build, and the site requires $650,000 worth of grading before it is suitable for construction. What is the proper cash ow amount to use as the initial investment in xed assets when evaluating this project? Why? Solution: The $5 million acquisition cost of the land six years ago is a sunk cost. The $5.4 million current after-tax value of the land is an opportunity cost if the land is used rather than sold o. The $10.4 million cash outlay and $650,000 grading expenses are the initial xed asset investments needed to get the project going. Therefore, the proper year zero cash ow to use in evaluating this project is $5,400,000 + 10,400,000 + 650,000 = $16,450,000

3. A piece of newly purchased industrial equipment costs $847,000 and is classied as sevenyear property under MACRS. After 5 years, the equipment will be sold for $80,000. Calculate the annual depreciation allowances and end-of-the-year book values over the 5 years that this equipment will be used. Also, compute the after-tax salvage value (use a tax rate of 34%). Solution: Year 1 2 3 4 5 Begin book value $847,000.00 725,963.70 518,533.40 370,393.10 264,602.80 MACRS 0.1429 0.2449 0.1749 0.1249 0.0893 Depr $121,036.30 207,430.30 148,140.30 105,790.30 75,637.10 End book value $725,963.70 518,533.40 370,393.10 264,602.80 188,965.70

ATSV = (1-T) x BTSV + T x EndBV = 117,048.30

4. Down Under Boomerang, Inc., is considering a new three-year expansion project that requires an initial xed asset investment of $2.7 million. The xed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,400,000 in annual sales, with costs of $960,000. There are no changes in NWC needs associated with the project. (a) If the tax rate is 35 percent, what is the OCF for each year of this project? (b) What is the projects NPV? (Use a discount rate of 12%.)

Solution: OCF = (1-T) x (Sales - Costs) + T x Depr = .65 x 1,440,000 + .35 x 900,000 = 1,251,000 0 OCF NCS ChNWC ----CFFA NPV = -2700000 1 1251000 0 2 1251000 0 3 1251000 0

---------------------------------------2700000 1251000 1251000 1251000 304,690.92

5. A ve-year project has an initial xed asset investment of $210,000, an initial NWC investment of $20,000, and an annual OCF of -$32,000. The xed asset is fully depreciated over the life of the project and has no salvage value. NWC is recovered at the end of the project. If the required return is 15 percent, what is this projects equivalent annual cost (EAC)? Solution: To calculate the EAC of the project, we rst need the NPV of the project. Notice that we include the NWC expenditure at the beginning of the project, and recover the NWC at the end of the project. The NPV of the project is: 0 1 2 3 4 5 OCF -32000 -32000 -32000 -32000 -32000 NCS -210000 ChNWC -20000 20000 ====================================================== CFFA -230000 -32000 -32000 -32000 -32000 -12000 NPV = -327,325.43 To nd EAC, use n=5, r=.15, pv=-327,325.43, FV=0, and solve for PMT. You should get EAC = PMT = 97,646.27

6. Guthrie Enterprises needs someone to supply it with 150,000 cartons of machine screws per year to support its manufacturing needs over the next ve years, and youve decided to bid on the contract. It will cost you $780,000 to install the equipment necessary to start production; youll depreciate this cost straight-line to zero over the projects life. You estimate that in ve years, this equipment can be salvaged for $50,000. Your xed production costs will be $240,000 per year, and your variable production costs should be $8.50 per carton. You also need an initial investment in net working capital of $75,000 (which will be recovered at the end of the project). If your tax rate is 35 percent and you require a 16 percent return on your investment, what bid price should you submit? Solution: ATSV = .65 x 50000 = 32,500 0 1 2 3 4 5 OCF ? ? ? ? ? NCS -780000 32,500 ChNWC -75000 75,000 ========================================= CFFA -855,000 ? ? ? ? ? + 107,500 To nd the needed OCF to break even, use your calculator with n=5, PV=-855,000, FV=107,500, r=16%, and solve for PMT. You should get OCF = PMT = 245,493.51. Now, using OCF = (Sales - Costs) x (1 - T) + Depr x T Depr = 780,000 / 5 = 156,000 Costs = FC + VC x Q = 240,000 + 8.5 x 150,000 = 1,515,000 solve for sales: Sales = ( OCF - Depr x T + Costs x (1 - T) ) / (1 - T) = 1,808,682 Or, 1,808,682 / 150,000 = 12.06 per box.