Assignment #1 – 10 marks
Question 1 – 5 marks
South Pack is considering investing in a packaging machine that costs $99,000 to purchase. There will be an additional $9,500 in non-capital (one time) pre-tax expense to install the machine. The company receives $2.10 in revenue per package while incu
ing $0.45 in variable costs per package. South pack expects to produce 34,000 packages per year using this machine. The annual fixed costs of operating the machine are $25,000. The machine will have a salvage value of $18,000 at the end of its 7 year lifespan. The company will increase its net working capital by $17,850 immediately to support the operation of the new machine, which would be completely recovered after the machine’s useful life. The machine`s CCA rate is 25%, the firm`s tax rate is 37%, and it uses an 11% cost of capital.
What is the machine’s NPV? Should South Pack acquire the machine?
Question 2 – 5 marks
Noble House Partners faces a project with unusual cash flows so it has asked you to weigh in on the value of retaining the option to shut down the project ahead of schedule. The project is one of many the company is pursuing at the moment and their CFO informs you that they would normally apply a 22% cost of capital to a risky project like this one.
a) Should the cost of capital be affected by whether or not this is Noble House's only investment project? Explain (1 mark)
) Their CFO explains the project as follows: An initial investment of $14 million in assets with a CCA rate of 30% (tax rate of 25%), after-tax cash flows the first year of $6 million. At the end of the first year, we will get a forecast of next year's value based on market conditions, either positive or negative with a 50% chance of either outcome. If things look positive, in year 2 cash flows will be $9 million after tax and if they look bad, $3 million. If the project assets can be salvaged for $9 million in year 1 or $6 million in year 2, how much is developing the option to shut the project down early (at t=1) worth to Noble House? (3 marks) Hint: draw two timelines
c) Explain
iefly how retaining the option to initiate a project can incur costs for a firm. (1 mark)