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FIN5FMA Tutorial 4 Solutions
FIN5FMA Tutorial 4 Solutions
Project A
$6,000 $8,000
NPV $10,000 $2,066 .12
1.10 (1.10) 2
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Project B
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1 1 /(1.10) 4
NPV $10,000 $4,000 $2,679 .46
0.10
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As the projects cannot be repeated, Project B should be selected because it has the
higher NPV.
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b. Assume that the projects can be repeated and that there are no anticipated
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changes in the cash flows. Use the replacement chain analysis to determine the
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This allows a direct comparison of both projects over their lowest common 4-year
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life.
Project A
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The NPV for Project B over the 4-year period (from Part a.) is $2,679.46. As such,
based on the replacement chain analysis, Project A should be selected over Project B
because it provides a higher NPV over the 4-year common-life period.
c. Make the same assumptions as in Part B. Using the equivalent annual annuity
(EAA) method, what is the EAA of the project selected?
Project A
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1 1 /(1.10) 2
Annuity factor ( PVIFA 10%, 2 ) 1.7355
0.10
Project B
1 1 /(1.10) 4
Annuity factor ( PVIFA 10%, 4 ) 3.1699
0.10
Based on the EAA method, Project A would be selected as it has the highest EAA
value. This decision signal is consistent with that from the replacement chain
approach in Part b.
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Problem 12-20 (Replacement analysis)
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The Erley Equipment Company purchased a machine 5 years ago at a cost of
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$90,000. The machine had an expected life of 10 years at the time of purchase,
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and it is being depreciated by the straight-line method by $9,000 per year. If the
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machine is not replaced, it can be sold for $10,000 at the end of its useful life. A
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new machine can be purchased for $150,000, including installation costs. During
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its 5-year life, it will reduce cash operating expenses by $50,000 per year. Sales
are not expected to change. At the end of its useful life, the machine is estimated
to be worthless. MACRS depreciation will be used, and the machine will be
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depreciated over its 3-year class life rather than its 5-year economic life; so the
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applicable depreciation rates are 33%, 45%, 15% and 7%. The old machine can
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be sold today for $55,000. The firm’s tax rate is 35%. The appropriate WACC is
16%.
a. If the new machine is purchased, what is the amount of the initial cash flow at
Year 0?
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b. What are the incremental net cash flows that will occur at the ends of Years 1
through 5?
This requires calculation of the depreciation allowances each year for the new
machine, and then using these to calculate the incremental cash flows from the
replacement of the new machine:
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Depreciable Depreciation Depreciation Change in
Year MACRS % basis allowance allowance depreciatio
(new) (old) n
1 33% $150,000 $49,500 $9,000 $40,500
2 45% $150,000 $67,500 $9,000 $58,500
3 15% $150,000 $22,500 $9,000 $13,500
4 7% $150,000 $10,500 $9,000 $1,500
5 0% $150,000 $0 $9,000 -$9,000
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Note
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The $6,500 deduction in the Year 5 NCF represents the after-tax opportunity cost of
not being able to sell the old machine at the end of its useful life.
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c. What is the NPV of this project? Should Erley replace the old machine?
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Explain.
Thus, the company should replace the existing machine with the new machine as the
incremental replacement NPV is positive.
A $750,000 14.0%
B $1,250,000 13.5%
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C $1,250,000 13.2%
D $1,250,000 13.0%
E $750,000 12.7%
F $750,000 12.3%
G $750,000 12.2%
a. Assume that each of these projects is independent and that each is just as risky
as the firm’s existing assets. Which set of projects should be accepted, and what
is the firm’s optimal capital budget?
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As the projects are independent and have the same level of risk as the overall firm, the
company should select all of the projects which have an IRR greater than the firm’s
WACC of 12.5%. Thus, the firm should select projects A, B, C, D and E and its
optimal capital budget is the sum of the costs of these projects ($5,250,000).
b. Now, assume that Projects C and D are mutually exclusive. Project D has an
NPV of $400,000, whereas Project C has an NPV of $350,000. Which set of
projects should be accepted, and what is the firm’s optimal capital budget.
If projects C and D are mutually exclusive, then the firm can only select one of them
rather than both. Based on the NPV criteria, the firm should select Project D as it
provided a higher NPV (and also has a higher IRR). As a result, the firm’s capital
budget is now $4,000,000 and includes projects A, B, D and E.
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c. Ignore Part b and assume that each of the projects is independent but that
management decides to incorporate project risk differentials. Management
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judges Projects B, C, D and E to have average risk; Project A to have high risk;
and Projects F and G to have low risk. The company adds 2% to the WACC of
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those projects that are significantly more risky than average, and it subtracts 2%
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from the WACC of those projects that are substantially less risky than average.
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Which set of projects should be accepted, and what is the firm’s optimal capital
budget?
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Low-risk projects
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Projects F and G will both be accepted because their IRRs (12.3% and 12.2%) are
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Average-risk projects
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Projects B, C, D and E will still be accepted because their IRRs are greater than
the firm’s average required return (WACC) of 12.5%
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High-risk projects
Project A will be rejected because its IRR of 14.0% is less than the required return
on high-risk projects of 14.5%
Thus, the selected projects are projects B, C, D, E, F and G and the firm’s optimal
capital budget is $6,000,000.
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successful and would generate annual after-tax cash flows of $6 million per year
during Years 1, 2, and 3. However, there is a 50% chance that X would be less
successful and would generate only $1 million per year for the 3 years. If Project
X is hugely successful, it would open the door to another investment, Project Y,
which would require an outlay of $10 million at the end of Year 2. Project Y
would then be sold to another company at a price of $20 million at the end of
Year 3. Martin’s WACC is 11%.
a. If the company does not consider real options, what is Project X’s NPV?
WACC = 11%; cash flows shown in millions.
0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
6 6 6 $5.662
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| | | -6.556
50% Prob. 1 1 1
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Expected NPV = 0.5($5.662) + 0.5(-$6.556) = -$0.447 million. The
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project would not be done.
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b. What is X’s NPV considering the growth option?
If the project is hugely successful, $10 million will be spent at the end of Year 2, and
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the new venture will be sold for $20 million at the end of Year 3.
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0 1 2 3 NPV @ Yr. 0
50% Prob. | | |
6 6 6
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-9 -4 26
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| | | -6.556
50% Prob. 1 1 1
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+$2.807 million
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