BAFI 355
BUSS207
Fall, 2019
Assignment 4
(Due by Dec. 11, 2019)
Please solve the following questions. If you prefer to work in a group in completing this assignment, you
may do so. Groups are limited to a maximum size of 3 students. If you work in a group, the group will
turn in one solution to the assignment and everyone in the group will receive the same grade on the
assignment. If you work in a group, please make sure that you write down the names of all of your group
members. If more than one group works together and turns in, substantially, the same work, this violates
the rules of the course and the rules on academic integrity, and penalties will be assessed. The assignment
is due at the beginning of class on the due date. Please show all the intermediate steps and calculations
when solving the problems and state your assumptions (if any). Please type your answers.
1. Reserve Inc. is considering a project that will result in initial after-tax cash savings of
$6 million at the end of the first year, and these savings will grow at a rate of 3
percent per year indefinitely. The firm has a target debt-equity ratio of 0.70, a cost of
equity of 16 percent, and an after-tax cost of debt of 6 percent. The cost-saving
proposal is somewhat riskier than the usual project the firm undertakes; management
uses the subjective approach and applies an adjustment factor of +2 percent to the
cost of capital for such risky projects (meaning that the cost of capital for the project
should be higher than the cost of capital for the firm by 2 percent). Under what
circumstances should this Reserve Inc. take on the project?
2. BAFI Inc., imposes a payback cutoff of three years for its international investment
projects. If the company has the following two projects available, should they accept
either of them? (To answer this question, please apply both payback period and
discounted payback period assuming the discount rate of 6%)
Year Cash Flow (A) Cash Flow (B)
0 -$50,000 -$70,000
1 30,000 8,000
2 15,000 20,000
3 10,000 30,000
4 10,000 500,000
3. Consider the following cash flows. Using MIRR with 8% discount rate, should we
take this project?
Year Cash Flow
0 -504
1 2,862
2 -6,070
3 5,700
4 -1,000
4. The ABC Inc., wants to set up a private cemetery business. According to the CFO,
John Smith, business is “looking up”. As a result, the cemetery project will provide a
net cash inflow of $40,000 for the firm during the first year, and the cash flows are
projected to grow at a rate of 7 percent per year forever. The project requires an
initial investment of $650,000. If ABC Inc., requires a 14 percent return on such
undertakings, should the cemetery business be started?
5. Suppose you have been hired as a financial consultant to ABC Inc., a large, publicly
traded firm that is the market share leader in radar detection systems (RDSs). The
company is looking at setting up a manufacturing plant overseas to produce a new
line of RDSs. This will be a five-year project. The company bought some land three
years ago for $6 million in anticipation of using it as a toxic dump site for waste
chemicals, but it built a piping system to safely discard the chemicals instead. The
land was appraised last week for $9.25 million. The company wants to build its new
manufacturing plant on this land; the plant will cost $14 million to build. The
following market data on ABC Inc.’s securities are cu
ent:
Debt: 10,000 8 percent coupon bond outstanding, 15 years to maturity, selling for 92
percent pf par; the bonds have a $1,000 par value each and make semiannual
payments.
Common stock: 250,000 shares outstanding, selling for $70 per share; the beta is 1.4
Market Information: 8 percent expected market risk premium; 5 percent risk-free rate
ABC Inc. has enough internally generated funds and has been advised to fund the
entire project using the internally generated funds only. ABC Inc.’s tax rate is 35
percent. The project requires $900,000 in initial investment to get operational.
A. Calculate the project’s initial Time 0 cash flow, taking into account all side effects.
B. The new RDS project is somewhat riskier than a typical project for ABC, primarily
ecause the plant is being located overseas. Management has told you to use an
adjustment factor of +2 percent to account for this increased riskiness. Calculate the
appropriate discount rate to use when evaluating ABC’s project.
C. The manufacturing plant has a five-year useful life, and ABC uses straight-line
depreciation. At the end of the project (i.e., the end of year 5), the plant can be
scrapped for $5 million. What is the annual depreciation of this plant?
D. The company will incur $350,000 in annual fixed costs. The plan is to manufacture
10,000 RDSs per year and sell them at $10,400 per machine; the variable production
costs are $8,500 per RDS. What is the annual operating cash flow, OCF, from this
project?
E. Finally, ABC’s president wants you to throw all your calculations, assumptions, and
everything else into the report for the chief financial officer; all he wants to know is
what the RDS project’s IRR and NPV are. What will you report?