Determine the free cash flows

Category: Business & Finance

Question 1 (a) HBV Incorporated is deciding whether to purchase equipment costing $754 000 that will enable it to reduce its labour costs by $137 000 per year for 13 years. The company expects to be able to salvage the equipment for $66 000 at the end, even though it will have been depreciated straight-line to zero over the first 6 years. The company tax rate is 30%. All payments occur at the end of each year. Complete the table below (or as many lines as you need) to determine the free cash flows each year. Item Year 0 Years 1 to 6 Years 7 to 12 Year 13 TOTAL FREE CASH FLOW (b) Suppose instead the cash flows per year turned out to be: Item Year 0 Years 1 to 6 Years 7 to 12 Year 13 TOTAL FREE CASH FLOW $-685 000 $143 000 $88 000 $117 000 Determine the internal rate of return (IRR) of those cash flows. There are several ways you can do this, besides trial and error, for example by using an Excel spreadsheet and the IRR function. Show how you did it. 21283043 (c) Sketch the NPV as a function of discount rate for the figures in (b) and label the significant points on the curve. This can be a hand sketch constructed using the significant points, or it can be a plot from Excel or similar. 21283043 Question 2 2 years ago you bought a mobile phone on a 3-year contract which cost you $0 up front and requires monthly payments of $69 at the end of each month. Today your friend Elizabeth Williams tells you she just bought a similar phone from another company for $126 up front and payments of only $50 at the end of each month. Furthermore, on the new plan, she can continue to pay the same $126 every 3 years to get a new handset. (a) If your friend stays on the new plan for ever, and continues to buy a new handset every 3 years, what is the NPV of her decision to sign up? Both you and Elizabeth have a discount rate of 1.04% per month. (b) You are wondering whether to break your contract and switch to the new provider to get the lower monthly rate. Your current provider has a break clause which means you have to pay a fee of $410 to terminate the contract today. Meanwhile the new phone company is so keen to attract new business they are offering financial incentives for customers from other providers. They are willing to pay you an amount today towards your costs of breaking your old contract if you sign up for 3 years. You would also have to bring your own handset initially (which the old company will unlock as part of the break fee) but then every 3 years you can pay the $126 to get a new handset. If you don’t switch now, your contract expires in 1 year and you can take up the fresh offer at that date like Elizabeth has today. How much would the incentive need to be for it to be worthwhile for you to break the old contract today? Assume used mobile phones have no salvage value. 21283043 Question 3 A 15-year project is expected to earn $312 700 after tax in its first year, and the annual amount is expected to grow through the life of the project at the inflation rate of 1.7% per annum. Your discount rate is 6.89% per annum. (a) Calculate the PV of this project using real cash flows. (b) Calculate the PV of this project using nominal cash flows. You should get the same present value. (Hint: This is a growing annuity. Either look up a formula for that, or recognise the growing annuity is the difference between two growing perpetuties and use the Gordon growth model for the growing perpetutities.) 21283043 Question 4 SJV Corporation is considering purchasing a machine for $827 000 which can produce green gizmos. The machine has a life of 7 years and then would have to be scrapped for no residual value. SJV will exit the green gizmo market whenever the machine is scrapped. The profit on each green gizmo is $2.74. SJV estimates there is a 66% probability that sales will be 16000 green gizmos per year, and 34% probability the sales will be 62000 green gizmos per year. The sales figures will become known during the first year, and will stay constant from then on, throughout the project. At the end of the 3rd year, SJV has an option to spend $185 000 on the machine to extend its life by a further 7 years, so it would have a total life of 14 years. There is no inflation and no tax. (a) Draw a decision tree. 21283043 (b) Determine the NPV of this project if SJV’s cost of capital is 10% per annum. 21283043

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