FIN 302 Lecture Notes - Lecture 1: Net Present Value, Cash Flow, Opportunity Cost
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XXX Industries is considering a new capital budgeting project that will last for three years. The initial investment outlay for project equipment is expected to be $110,000. The equipment will be straight-line depreciated down to zero book value over the three year period. The expected market value of the project assets is forecasted to be $50,000 when the project is liquidated at the end of the third year. Project will require $7,000 Net Working Capital investments in years 1 and 2. The project does not require any investment in fixed assets during years 1 and 3, but a $10,000 investment is projected in year 2. XXXâs cost of capital is 12% and the project does not have a distinct risk profile. XXXâs tax rate is 35%. Based on extensive research, analysts have prepared the following incremental revenues and before tax costs:
Year | 0 | 1 | 2 | 3 |
Sales (Revenues) | 100,000 | 100,000 | 100,000 | |
- Cost of Goods Sold (50% of Sales) | 50,000 | 50,000 | 50,000 | |
Depreciation | 36,667 | 36.667 | 36,667 | |
EBIT | 13,333 | 13,333 | 13,333 | |
Capital Expenditures | -110,000 | 0 | -10,000 | 0 |
Note: Additional fixed capital investments are depreciated straight line over a three-year period; the first depreciation expense is deducted at the end of the year following the investment. The 50,000 liquidation value reflects enhancements realized through capital investments in fixed assets.
1. The after tax project cash flow including the terminal cash flow for the project in year 3 is closest to ___________?
2. The NPV and IRR of the DKK Project is closest to _________ (round up your solution to the nearest integer for NPV)
$14,670, 18.415 |
$4,866; 14.10% |
$12,179, 17.38% |
$7,712; 15.35% |
none of the numerical choices shown is correct |
Seth Bullock, the owner of Bullock Gold Mining, is evaluating a new gold mine in South Dakota. Dan Dority, the companyâs geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for eight years, after which the gold would be completely mined. Dan has taken an estimate of the gold deposits to Alma Garrett, the companyâs financial officer.
Alma has been asked by Seth to perform an analysis of the new mine and present her recommendation on whether the company should open the new mine. Alma has used the estimates provided by Dan to determine the revenues that could be expected from the mine. She has also projected the expense of opening the mine and the annual operating expenses. If the company opens the mine, it will cost $525 million today, and it will have a cash outflow of $35 million nine years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in the table.
Bullock Mining has a required return of 12 percent on all of its gold mines.
Provided Table below | |
Year | Cash Flow |
0 | -$525,000,000 |
1 | $74,000,000 |
2 | $97,000,000 |
3 | $125,000,000 |
4 | $157,000,000 |
5 | $185,000,000 |
6 | $145,000,000 |
7 | $125,000,000 |
8 | $102,000,000 |
9 | -$35,000,000 |
Required Return: 12%
1. What type of cash flow are these for the proposed mine for Bullock Gold Mining above? Conventional or non-conventional? If non-conventional, explain what issues will occur with IRR rule
2. Calculate the Payback period below. If Bullock Gold Mining payback limit is 4 years, would they accept or reject this independent project based on Payback Period rule?
Year | Cash Flow | 1st Calculate Cumulative Cash Flows | NOTES to calculate 1st each row: | 2nd Calculate Payback Period (see answer below): | |||||
0 | -$525,000,000 | ||||||||
1 | $74,000,000 | ||||||||
2 | $97,000,000 | ||||||||
3 | $125,000,000 | ||||||||
4 | $157,000,000 | ||||||||
5 | $185,000,000 | ||||||||
6 | $145,000,000 | ||||||||
7 | $125,000,000 | ||||||||
8 | $102,000,000 | ||||||||
9 | -$35,000,000 |
3. Calculate the net present value (NPV) of the proposed mine for Bullock Gold Mining below. Would they accept or reject this independent project based on NPV rule? Note: required return is 12%.
R/I% | NPV result calc/input$ below |
12% |
4. Calculate the internal rate of return (IRR) of the proposed mine for Bullock Gold Mining below. Would they accept or reject this independent project based on IRR rule? (Answer carefully based on answer to question 1 above). Note: required return is 12%.
R/I% | IRR result calc/input% below |
12% |
5. Based on your analysis, should the company open the mine? Which of the Investment Criteria calculated above (Payback, NPV and IRR) should Bullock Gold Mining use as their decision factor, and why?
Question 1 Diana Dennison is a financial analyst working for a large chain of discount retail stores. Her company is looking at the possibility of replacing the existing fluorescent lights in all of its stores with LED lights. The main advantage of making this switch is that the LED lights are much more efficient and will cost less to operate. In addition, the LED lights last much longer and will have to be replaced after ten years, whereas the existing lights have to be replaced after five years. Of course, making this change will require a large investment to purchase new LED lights and to pay for the labor of switching out tens of thousands of bulbs. Dian plans to use a 10-year horizon to analyze this proposal, figuring that changes to lighting technology will eventually make this investment obsolete. Diana’s friend and coworker, David, has analyzed another energy-saving investment opportunity that involves replacing outdoor lighting with solar-powered fixtures in a few of company’s stores. David also used a 10-year horizon to conduct his analysis cash flow forecasts for each project appear below. The company uses a 10% discount rate to analyze capital budgeting proposals.
Year |
LED project |
Solar project |
0 |
-RM4,200,000 |
-RM500,000 |
1 |
700,000 |
60,000 |
2 |
700,000 |
60,000 |
3 |
700,000 |
60,000 |
4 |
700,000 |
60,000 |
5 |
1,000,000 |
60,000 |
6 |
700,000 |
60,000 |
7 |
700,000 |
60,000 |
8 |
700,000 |
60,000 |
9 |
700,000 |
60,000 |
10 |
700,000 |
60,000 |