Fin 502 - Business Finance

Homework 3 Solutions
Winter 2020
Due January 27

1 Individual Questions
1. (1 pt) Suppose you’ve been operating a hot dog cart at the tailgate before Husky football
games. Business went so well this season that you are considering buying a second cart for
next year. It will cost you $5000 immediately to buy a new cart and you expect to make an
additional $1500 a year with this cart for the next 5 years (received at the end of the year).
Assuming your cost of capital is 7% EAR, what is the NPV of this project?

P5 $1,500
NPV = -$5,000 + t=1 (1.07)t = $1, 150.30

2. (1 pt) (1 pt) You own a trucking company and are buying new trucks. The new trucks will
cost you $3 million dollars right now and you expect it to create cash flows of $500,000 a year
(received at the end of the year) for 10 years. Your required rate of return is 10%. According
to the IRR rule, should you go forward with this project?

Calculate IRR by P
finding the rate that makes the NPV=0.
0= -$3,000,000 + 10 $500,000
t=1 (1+r)t
r = 10.558%

3. (1 pt) Recall the examples in question 1 and question 2. Suppose both the hot dog com-
pany and the trucking company have a required payback period of 4 years or less. Which of
these two projects will be accepted? For the project that is rejected, how many more years
would need to be added to the company’s required payback period policy before it is accepted?

The hot dog project will be accepted since the cash flows from the cart in the first 4 years
will be $6,000 which is above the initial investment of $5,000. The trucking project will be
rejected since the cash flows over the first 4 years are $2 million which is less than the initial
investment of $3 million. The payback period policy would have to be 6 years or longer for
us to accept this project.

4. (2 pts) You are considering making a movie. The movie is expected to cost $100 million
upfront and take a year to make. After that, it is expected to make $40 million (at the end of
year two) and $25 million per year for the following four years (paid at the end of the year).
What is the payback period of this investment? If you require a payback period of two years,

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 will you make the movie? What is the NPV of the movie if the cost of capital is 12% EAR?

The payback period is 5 years since it will take 5 years before the cash flows generated from
the project exceed $ 100 million.Therefore you will not make the movie if your required pay-
back period is 2 years.

Time Today 1 Yr 2 Yrs. 3 Yrs. 4 Yrs. 5 Yrs. 6 Yrs.

Cash Flows -$100M $0 $40M $25M $25M $25M $25M

Using a discount rate of 12%

Pthe NPV is:
$40M 6 $25M
NPV = -$100M + (1.12) 2 + t=3 (1.12)t = −$7.57M so again you would not take the project.

5. (2 pts) Bill Clinton reportedly was paid $10 million to write his book My Life. The book
took three years to write. In the time he spent writing, Clinton could have been paid to make
speeches. Given his popularity, assume that he could earn $6 million per year (paid at the
end of the year) speaking instead of writing. Assume his cost of capital is 9% per year EAR.

(a) What is the NPV of agreeing to write the book (ignoring any royalty payments)? As-
sume that Clinton was paid $10 million upfront. Based on the NPV rule, should he
write the book?

Use the NPV formula:

NPV = $10M + 3t=1 −$6M
P
(1.09)t = −$5.19M so he shouldn’t write the book.
(b) Assume that once the book was finished, it was expected to generate royalties of $4.5
million in the first year (paid at the end of the year) and these royalties were expected
to decrease at a rate of 20% per year in perpetuity. What is the NPV of the book with
royalty payments? Now that he receives royalties, should Clinton write the book based
on the NPV rule?

The royalties are a declining perpetuity. Since they start in year 4, the present value in
year 3 is:
$4.5M
P V (perpetuity)yr3 = 0.09−(−.20) = $15.52M .

The NPV including royalties, with discounting the declining perpetuity, is:
NPV = NPV(without royalties) + P V (perpetuity)yr3
NPV = -$5.19M + $15.52M
(1.09)3
NPV = -$5.19M + $11.98M = $6.79M
So he should take the offer if royalties are included.

2 Group Questions
1. (3 pts) Suppose Disney wants Robert Downey Jr. to come back and make another Avengers
movie. To convince him to return they pay him $60 million up front and promise to pay him
4.7% of the box office gross when the movie is released in 4 years. Assume the movie will
make $2 billion dollars and that filming the movie will take 3 years, during which he would
have made $50 million a year doing other projects (paid at the end of the year).

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 (a) What is the IRR for this project?
Find the value
P of r$50M
that solves:
0 = $60M - 3t=1 (1+r) $94M
t + (1+r)4

There are 2 such values of r that solve this: 9.15% and 19.9%.
(b) Over what range of personal cost of capitals should Robert accept the offer? (Hint: It
may help to draw a graph)
If you draw a graph of r vs NPV, you will see that the NPV is positive for r less than
9.15% and r greater than 19.9%. NPV is negative in between these two values. You
could also plug in values for r different ranges and see which result in a positive NPV.
Thus, Robert should do the movie if his cost of capital is less than 9.15% or greater than
19.9%.
(c) Why is (or is not) IRR a good criterion for him to use here?
IRR isn’t ideal here because two different values are returned. It would probably be
more efficient for Robert to just estimate his personal cost of capital and check the NPV
directly.

2. (2 pts) Starbucks purchased computer equipment three years ago for $600,000 and it can now
be sold for $400,000. The equipment is being depreciated to zero using a six-year straight-line
schedule. Starbucks’ tax rate is 20%. What is Starbucks’ depreciation expense each year and
what is the after-tax cash flow from selling the equipment in three years?

The depreciation expense each year is:

Depreciation = Initial Cost - Salvage Value
Useful life
$600,000−$0
6 = $100, 000
The after-tax cash flow from selling the equipment in three years is $400,000 - 0.2*($400,000
- $300,000) = $380,000, where $300,000 is the book value of the equipment after 3 years.

3. (3 pts) 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 $10,000 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 costs should be included in Home
Builder Supply’s analysis?

(a) The cost of the land where the store will be located.
No, this is a sunk cost since the company already owns the land.
(b) The value of the land if sold.
Yes, this is the opportunity cost of not selling the land.
(c) The cost of demolishing the abandoned warehouse and clearing the lot.
Yes, this is a cost that is incurred if the project is undertaken.
(d) The loss of sales in the existing retail outlet if customers switch stores.
Yes, this is a side effect (erosion).
(e) The $10,000 in market research spent to evaluate customer demand.
No, this is a sunk cost that was incurred last month.

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 (f) Construction costs for the new store.
Yes, this is a capital expenditure.
(g) Interest expense on the debt borrowed to pay the construction costs.
No, this is a financing cost.

4. (4 pts) You are evaluating a project to build an oil pipeline in one of the emerging markets.
Building the pipeline will take 8 annual investments, each of which is paid at the beginning of
the year, starting immediately. The first of these investments is $20 million and the amount
of the remaining 7 investments is expected to increase by 3% per year. The pipeline will
commence its operations in year 9 and will transport 3,500,000 barrels of oil per year in per-
petuity. As the pipeline owner, you will collect an annual cash flow equal to 10% of the total
value of transported oil, with cash flows occurring at the end of each year. If the discount
rate is 12%, what is the minimum price of oil per barrel under which you would accept this
project (i.e., ensure that NPV≥0)? For simplicity, assume that oil prices are constant over
time and that the costs of running the pipeline are negligible.

First consider the 8 annual investments. You pay $20 million immediately and additional $20
million (plus 3% growth) a year at the beginning of each of the next 7 years. The discount
rate is also 12%.
P These outflows n−1 are:
N P Voutf low = 8n=1 −20 ∗ ( 1.03
1.12 )

If we label our first payment as occurring at the beginning of year one, and our last payment
at the beginning of year eight, we receive our first perpetuity payment at the END of year
nine. The value of the perpetuity is our dividend (3.5M barrels * price*10%) divided by the
discount rate (12%). In other words, the value of the perpetuity is V(p) = 2.917p.Since we
start receiving these dividends at the end of year 9 we must discount it to the beginning of
2.917p
year one (that is, now). So the present value of the perpetuity is (1.12)9

So our
P problem is1.03
to find the value of p that solves:
0 = 8n=1 −20 ∗ ( 1.12 2.917p
)n−1 + (1.12)9 . Algebraic manipulations will tell us that the solution price

is $115.55.