Homework 2 – Project Evaluation – Advanced Corporate Finance
Question 1: The purpose of this question is to evaluate a proposed project. This project has the following cash flows:
Yea
0
1
2
3
4
5
6
CF ($M)
-1,000
250
350
400
520
600
-800
The company can reinvest cash inflows at a rate of 15%, the company’s cost of capital is 12%.
a) What is the NPV of the project?
) What is the IRR of the project?
c) What is the MIRR of the project (please demonstrate both methods)?
Question 2: MacGiver Inc., owns a plot of land in a large metro area. The company could use the land in one of two ways. Either a gas station or a parking garage can be built and operated, but not both. The following are the cash flows from either choice (in $’000):
Yea
0
1
2
3
4
5
Gas
-1,200
470
470
470
470
470
Parking
-3,500
1,200
1,200
1,200
1,200
1,200
The cost of capital for both projects is 12%.
a) What is the NPV of each project?
) What is the IRR of each project?
c) What is the investment recommendation given your answers in a) and b) and the facts of the question?
Question 3: You are the CFO of FloorCovering America Inc. As part of the planning and budgeting process, each division head from the company’s five divisions has submitted their capital requests. The following are the facts and figures from each division (in $’000):
Division
I
II
III
IV
V
Capital Requested
-10,000
-30,000
-30,000
-20,000
-10,000
NPV
5,160
2,010
490
4,870
2,290
IRR
29%
12%
11%
23%
15%
Profitability Index
1.5
1.1
1.0
1.2
1.2
The projects above are “All or Nothing” – meaning for example that division I requires an investment of $10M immediately, and cannot accept partial funding of its project. The projects are NOT mutually exclusive; they are independent in the sense that if capital was UNCONSTRAINED, all five projects could be funded simultaneously. The cost of capital for each of the projects is 10%.
a) Suppose the company has unlimited capital and can invest in all of the projects if deemed optimal, which of the projects should be funded? Why?
) Because of challenging capital market conditions, the company can only raise $50M for investment in next years’ projects.[footnoteRef:1] Which of the projects should be funded? Why? [1: What is Capital Rationing? – Investopedia
Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget. Companies may want to implement capital rationing in situations where past returns of an investment were lower than expected.
Capital rationing is essentially a management approach to allocating available funds across multiple investment opportunities, increasing a company's bottom line. The combination of projects with the highest total net present value (NPV) is accepted by the company. The number one goal of capital rationing is to ensure that a company does not over-invest in assets. Without adequate rationing, a company might start realizing decreasingly low returns on investments and may even face financial insolvency.]
Question 4: You are the CFO of The Maxim Group Inc. As part of your planning process, you are considering outsourcing production of a small component (the widget) of the company’s main product. You have created the following scenario analysis for next year’s production:
Outcome
Probability
Widget Units Needed
Exceptional
35%
1,000,000
Average
50%
800,000
Poo
15%
700,000
IF the company continues to manufacture this product “in-house”, the variable cost per unit is $15.33. The fixed costs are $10M in total. ALTERNATIVELY, the company could outsource production of the widget, and the new supplier has quoted a price of $27 per widget. Based on the above facts, and ignoring other more esoteric concepts as supply chain security, should the company outsource production of the widget? Why – there may not be an unambiguous answer to this question?
Question 5: This question tests your understanding of the various form of “
eakevens”. A proposed project has the following facts:
· Investment required today, t=0, $10M (cash outflow)
· Length of project, 8 years
· Forecast unit sales per year, 600,000
· Sales price per unit, $80
· Variable cost, $36 per unit
· Fixed costs, $20M per year – (includes $5M of depreciation)
· Taxes, 20%
· Net working capital which consists of, inventory plus A/R less A/P (very simple), requires an investment of $500K today, t=0, which is INCLUDED in the above “Investment required today, t=0, $10M”
· The NWC investment of $500K noted in the last bullet point will reverse at the end of the project, in other words, cash flows will be higher by $500K at t=8
· Cost of capital, 10%.
a) What is the contribution per unit?[footnoteRef:2] [2: Contribution Margin - Bloomberg
A cost accounting concept that allows a company to determine the profitability of individual products. It is calculated as follows:
(Product Revenue - Product Variable Costs) / Product Revenue
The phrase "contribution margin" can also refer to a per unit measure of a product's gross operating margin, calculated simply as the product's price minus its total variable costs.]
) How many units must the company sell PER YEAR to
eakeven on a net income (or net earnings) basis?
c) How many units must the company sell PER YEAR to
eakeven on a free cash flow basis in years 1 through 7 (they are identical so only one calculation needs to be shown)?
d) How many units must the company sell to
eakeven on an NPV basis?
Question 6: Bob Tate is the director of strategy for a small truck delivery company. The company operates a fleet of 100 trucks. Of these, 36 trucks will need to be replaced this year. Bob has two choices, either diesel or green trucks. The following are the facts for each possibility:
For EACH diesel truck: Cost = $175K; life, 3 years (the trucks lose value quickly after 3 years of operations as the mileage reaches 200K); salvage value at end of three years, $50K; annual operating costs, $90K.
For EACH green truck: Cost = $220K; life, 4 years; salvage value at end of four years, $100K; annual operating costs, $75K.
Which choice should Bob make, diesel or green if the cost of capital is 10%; you may assume that the time period covered by this decision is 12 years IF you wish, and you can ignore the other 64 of the 100 trucks in the fleet? (Ignore taxes, depreciation, and ignore diversification.)