ECO 550 Week 10 - Check Your Understanding Ch. 17 Problems 1, 5, and 9(c) (All Questions Answered)
ECO 550 Week 10 - Check Your Understanding Ch. 17 Problems 1, 5, and 9(c) (All Questions Answered) fin571
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Date Created: 11/11/15
ECO 550 Week 10 Check Your Understanding Chapter 17 Problems 1 5 and 9c 1 A firm has the opportunity to invest in a project having an initial outlay of 20000 Net cash in ows before depreciation and taxes are expected to be 5000 per year for five years The firm uses the straightline depreciation method with a zero salvage value and has a marginal income tax rate of 40 percent The firm s cost of capital is 12 percent a Compute the internal rate of return and the net present value a NINV 20000 and NCF 5000 4000l 4 4000 4600year 20000 4600Interest factor for 5 years 200004600 43478 Interest factor 43478 which helps to find the internal rate of return IRR of this project This interest factor represents the present value of a 1 annuity for 5 years discounted at r Looking up 43478 in Table 5 this value falls between 44518 and 43295 which corresponds to discount rates of 4 and 5 respectively for an internal rate of return Interpolating between these values yields an internal rate of return of approximately 485 which is far lower than the firm s cost of capital of 12 Students can use a calculator or Excel to find the IRR which is 4847 For the NPV students can use tables to find the Annuity Interest Factor at 12A to be 36048 to find NPV 460036048 20000 3418 Alternatively financial calculators or Excel can find the NPV to be 341803 b Should the firm accept or reject the project Since the NPV of the project is negative the firm should reject the project Likewise by the IRR criterion the project should be rejected because the internal rate of return of 485 is less than the cost of capital of 12 5 The Charlotte Bobcats a professional basketball team has been offered the oppor tunity to purchase the contract of an aging superstar basketball player from an other team The general manager of the Bobcats wants to analyze the offer as a capital budgeting problem The Bobcats would have to pay the other team 800000 to obtain the superstar Being somewhat old the basketball player is ex pected to be able to play for only four more years The general manager figuresthat attendance and hence revenues would increase substantially if the Bobcats obtained the superstar He estimates that incremental returns additional ticket revenues less the superstar s salary would be as follows over the fouryear period YEAR INCREMENTALRETURNS 1 450000 2 350000 03 275000 4 200000 The general manager has been told by the owners of the team that any capital expenditures must yield at least 12 percent after taxes The firm s marginal in come tax rate is 40 percent Furthermore a check of the tax regulations indicates that the team can depreciate the 800000 initial expenditure over the fouryear period Depreciationyear 8000004 200000 This involves a series of payments of unequal value NCF1 450000 200000 1 4 200000 350000 NCF2 350000 200000 1 4 200000 290000 NCF3 275000 200000 1 4 200000 245000 NCF4 200000 200000 1 4 200000 200000 a Calculate the internal rate of return and the net present value to determine the desirability of this investment IRR 1494 NPV 45176 because The IRR calculation 800000 3500001r1 2900001r2 2450001r3 2000001r4 We can find the r that makes the lefthand and righthand side equal by trial and error using PVIF tables or with a financial calculator or using Excel The IRR equals 1494NPV calculation NPV 35000089286 29000079719 24500071178 20000063552 800000 45176 b Should the Bobcats sign the superstar Given that the cost of capital is above zero at 12 then the net present value is also positive Since that is the case given here then the Bobcats should purchase the contract of the superstar Also given that the internal rate of return is approximately 149 and it exceeds the cost of capital the investment should be a positive one It is a good idea to accept this deal 9 The state of Glottamora has 100 million remaining in its budget for the current year One alternative is to give Glottamorans a onetime tax rebate Alternatively two proposals have been made for state expenditures of these funds The first proposed project is to invest in a new power plant costing 100 mil lion and having an expected useful life of 20 years Projected benefits accruing from this project are as follows YEARS BENEFITSPERYEARMILLIONS 1 5 0 6 20 20 The second alternative is to undertake a job retraining program also costing 100 million and generating the following benefits YEARS BENEFITSPERYEARMILLIONS 1 5 20 6 10 14 11 20 4 The state Power Department argues that a 5 percent discount factor should be used in evaluating the projects because that is the govemment s borrowing rate The Human Resources Department suggests using a 12 percent rate because that more nearly equals society s true opportunity rateIn Gottamora they could invest in a new power plant or enter into a job retraining program both costing 100 million c What rate do you believe to be more appropriate Using the 5 rate cannot be justified since this would result in a misallocation of society39s resources If funds can earn a 12 return in the private sector it is not optimal to reallocate them to the public sector where the return is only 5 In practice the determination of the appropriate discount rate to be used for public programs should be a function of the source of the funds private consumption or private investment as well as the relative amounts coming from these two sources The opportunity cost for consumption source funds is likely to be lower than that for investment source funds
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