FIN2010 Problem Set 3

Due 2025-4-10 at 5 PM

1. A pencil company currently produces 200,000 units a year. It buys pencil tops from an outside supplier at a
price of $2 per top. The plant manager believes that it would be cheaper to make these tops rather than buy
them. Direct production costs are estimated to be only $1.50 per top. The necessary machinery would cost
$150,000. This investment in machinery could be written off for tax purposes using straight-line depreciation
over 8 years with no salvage value. The plant manager estimates that the operation would require an
additional working capital investment of $30,000 at year 0, which is recoverable at the end of the 10 years.
(In other words, net working capital goes up by $30,000 today 0 and goes down by $30,000 at the end of the
tenth year.) If the company pays tax at a rate of 35% and the cost of capital is 15%, would you support the
plant manager’s proposal of purchasing machinery to make tops rather than buying tops from an outside
supplier? Assume the machinery can last for at least 10 years and all operating cash flows occur at the end
of the year (that is, the machinery will be depreciated over 8 years, but the machine can be used for 10
years).

2. Two years ago, the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene Krabs, has
learned that a new grill is available that will cook Krabby Patties twice as fast as the existing grill. This new
grill can be purchased for $80,000 and would be depreciated straight line over 8 years, after which it would
have no salvage value. Eugene Krab expects that the new grill will produce gross profits of $50,000 per year
for the next eight years, while the existing grill produces gross profits of only $35,000 per year for the next
eight years. The current grill is being depreciated straight line over its useful life of 10 years after which it
will have no salvage value. All other operating expenses are identical for both grills. The existing grill can be
sold to another restaurant now for $30,000. The Krusty Krab's tax rate is 35%. Assume Krusty Krab
experiences very high capital gains without considering this new project of asset replacement.
(1) Calculate the free cash flow in year 0 for the grill replacement proposal.
(2) Calculate the free cash flow in year 1.

3. Your division is considering two investment projects, each of which requires an up-front expenditure of $25
million. You estimate that the cost of capital is 10% and that the investments will produce the following
after-tax cash flows (in millions of dollars):
Year Project A Project B
1 5 20
2 10 10
3 15 8
4 20 6

(1) Using the payback periods as the criterion, will you accept Project A and Project B, respectively? The firm’s
preset policy is to accept any project if the payback period is less than 2 years.

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 (2) What are the IRRs of the two projects, respectively?
(3) If the two projects are mutually exclusive and the cost of capital is 5%, which project should the firm
undertake?
(4) If the two projects are mutually exclusive and the cost of capital is 15%, which project should the firm
undertake?

4. Huawei has spent ￥1.5B in R&D and is ready to launch the first foldable cellphone Mate X. However, they
are not sure about whether consumers will like their new phones. They can choose to launch the product at
year 0 or year 1. The costs of production will be the same whether they enter the market in year 0 or year 1.
The life of Mate X will be 2 years in either case. The relevant cash flow information is given below.
Suppose the unit sales will be X and 0.5X in the first and second year. The unit price is￥17000 in the first
year and ￥15000 in the second year, and the unit COGS is ￥8000 in the first year and ￥7000 in the second
year. In order to produce Mate X, Huawei needs to purchase a piece of equipment at ￥3.6 billion at the
beginning of production, and the equipment will be depreciated over 3 years based on the straight-line
method with no salvage value. Also, in order to produce Mate X, Huawei needs to pay an additional salary of
￥1.8B in the first year and ￥0.5B in the second year. The required net working capital is ￥1000 for each
unit of sales in the first year and ￥500 for each unit of sales in the second year. Suppose the cost of capital
is 15% per year. Tax rate for Huawei is 25% and Huawei has enough earnings to realize all tax savings in all
the years.
Launch Year Launch Year+1 Launch Year+2 Launch Year+3
Revenue 17000*X 15000*0.5X
COGS 8000*X 7000*0.5X
Overhead (salary) 1.8B 0.5B
CAPEX (capital 3.6B
expenditure)
Depreciation 1.2B 1.2B 1.2B
Required NWC 0 1000*X 500*X 0

(1) Calculate the project NPV at the time of launch date as a function of X.
Use the following information to answer questions (2), (3), and (4):
Suppose if they launch the phone in year 0, there is a 60% chance that consumers like the product, and X will
be 1 million units. There is a 40% chance that consumers are disappointed about the product, and X will be
0.2 million units. If they launch the phone in year one, they will know whether consumers like foldable
phones, and they can choose to not launch if the situation is unfavorable. If they launch the phone in year 1
and the consumers like foldable phones, X will be 0.9 million. If they launch in year 1 even though
consumers do not like foldable phones, X will be 0.2 million.
(2) What is the expected NPV if they launch in year 0?
(3) What is the NPV at year 1 if they launch in year 1? Calculate the NPV for both scenarios. Should they
launch the phone if it is revealed that consumers do not like foldable phones?
(4) What is the option value of delaying the launch? (Hint: Option value = NPV (delaying) – NPV (not
delaying))

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5. Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany
plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared
the following incremental cash flow projections:
Year 0 1 2 3
Sales (Revenues) 100,000 100,000 100,000
- Cost of Goods Sold 50,000 50,000 50,000
- Depreciation 30,000 30,000 30,000
= EBIT 20,000 20,000 20,000
- Taxes (35%) 7000 7000 7000
= unlevered net income 13,000 13,000 13,000
+ Depreciation 30,000 30,000 30,000
- changes to working capital +5000 +5000 -10,000
- capital expenditures 90,000

(1) What is the NPV of this project?