Three projects are being evaluated by a national financial corporation. The table below summarizes expected cash flows for each of the three projects over the next seven years. Due to budget limitations, the corporation will only choose one project out of the three projects. At a MARR (Minimum Acceptable Rate of Return) of 8%, answer the following.
Project
Initial Cost
Expenses per Year
Return at end of year 7
1
$100,000
$40,000 for the first year, increasing by $2,000 per year thereafter
$600,000
2
$360,000
$85,000 for the first year, increasing by $4,000 per year thereafter
$1,600,000
3
$185,000
$55,000 for the first year, increasing by $3,000 per year thereafter
$850,000
a) Determine the economically best project for the corporation using a rate of return method.
b) Is it always the case for the project with the highest rate of return to be the economically best alternative?
c) Are you expecting different results if the comparison is based on Present Worth? ( Hint: no calculations are needed).
Three projects are being evaluated by a national financial corporation. The table below summarizes expected cash flows for each of the three projects over the next seven years. Due to budget limitations, the corporation will only choose one project out of the three projects. At a MARR (Minimum Acceptable Rate of Return) of 8%, answer the following.
Project | Initial Cost | Expenses per Year | Return at end of year 7 |
1 | $100,000 | $40,000 for the first year, increasing by $2,000 per year thereafter | $600,000 |
2 | $360,000 | $85,000 for the first year, increasing by $4,000 per year thereafter | $1,600,000 |
3 | $185,000 | $55,000 for the first year, increasing by $3,000 per year thereafter | $850,000 |
a) Determine the economically best project for the corporation using a rate of return method.
b) Is it always the case for the project with the highest rate of return to be the economically best alternative?
c) Are you expecting different results if the comparison is based on Present Worth? ( Hint: no calculations are needed).
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Final Project Scenario
You are an economist for the Vanda-Laye Corporation, which produces and distributes outdoor cooking supplies. The company has come under new ownership and management and will be undergoing changes in its product lines and operating structure. As an economist, your responsibilities include examining the market factors that affect success or failure of a product, including the supply and demand for the product, market conditions, and the behavior of competitors with similar products.
The new management has identified several possible investments for the coming year. It has asked you and your team to evaluate the possibilities and make a recommendation to the board of directors. Jorge has identified two mutually exclusive opportunities (Investment A) and two independent opportunities (Investment B) and assigned you the task of making a recommendation on the investments.
Investment A
Your company would like to increase its product lines. Two alternatives are available, a new line of outdoor smokers and a new line of outdoor grills. The two lines are mutually exclusive, meaning that only one of these investment alternatives can be selected. The projected cash flows and their respective probabilities for each alternative are given in the table. There are three possible levels of demand and their corresponding probabilities, which depend on the state of the economy.
Click here to download the table for Investment A. (Table Below)
Investment A
Demand | Probability | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
Outdoor Smoker | ||||||
High | 0.2 | $800,000 | $900,000 | $1,000,000 | $1,100,000 | $1,500,000 |
Moderate | 0.6 | $500,000 | $700,000 | $800,000 | $960,000 | $1,240,000 |
Low | 0.2 | $200,000 | $350,000 | $500,000 | $600,000 | $750,000 |
Outdoor Grill | ||||||
High | 0.2 | $600,000 | $750,000 | $850,000 | $975,000 | $5,160,000 |
Moderate | 0.6 | $450,000 | $500,000 | $700,000 | $825,000 | $4,980,000 |
Low | 0.2 | $150,000 | $220,000 | $370,000 | $500,000 | $4,750,000 |
The two alternatives carry equal risk and should be evaluated at the company's cost of capital. The cost for the new smoker line will be $7,000,000. Also, the company has been guaranteed a buyer for the new line at the end of the fifth year. The buyer has agreed to purchase the new line for $7,900,000. The outdoor grill alternative will cost $3,987,000 and also has a guaranteed buyer, who has agreed to pay $4,000,000 at the end of the fifth year.
Investment B
Investment B involves two independent investment opportunities. The decisions on these two investment alternatives are also independent of Investment A. Investment B-1 involves a new packaging machine, which will eliminate the need for a local firm for packaging Vanda-Laye's products. The cost of this machine will be $24,000, and the expected revenues from this opportunity are given in the table and are considered to be of average risk. Investment B-2 is the purchase of a new computer system that will allow the company to sell its products on the Internet worldwide. The cost of this new system will be $29,000, with the expected cash flows after taxes given in the table.
Click here to download the table for Investment B. (Table Below)
Investment B
Year | Cash Flows | |
Packaging Machine | Computer System | |
1 | $8,400 | $9,100 |
2 | $4,800 | $8,800 |
3 | $7,800 | $8,300 |
4 | $6,200 | $8,000 |
5 | $5,500 | $5,100 |
6 | $4,600 | $4,000 |
7 | $3,000 | $3,500 |
Jorge has asked you to provide detailed responses to the following:
Management of Vanda-Laye has determined that the capital structure of the company will involve 30% debt and 70% common equity. This structure will be used to finance all investments by the company. Currently, the company can sell new bonds at par, with a coupon rate of 7%. Any new common stock can be sold for $45, with a required return (or cost) of 15.57%. Using Microsoft Excel, calculate the company's cost of capital to be used in the evaluation of possible investment projects.
For Investment A:
Using Microsoft Excel, create a decision tree. Indicate the various levels of demand and their respective probabilities. Also, include the calculations for the expected cash flows.
Calculate the expected NPV for each alternative. Explain the decision rules for making a selection between the two alternatives on the basis of the expected NPV.
Assuming the two alternatives are mutually exclusive, specify which alternative you would recommend to the company. Explain why.
If the two alternatives were independent of each other, specify which project you would select. Would you accept both projects if funding were available for both? Explain your answer.
For Investment B:
Using Microsoft Excel, calculate the NPV for each alternative.
Using the decision-making criteria for the NPV, specify which alternative you would select if the two alternatives were mutually exclusive. Explain your answer.
Given that the two alternatives are independent of each other, specify which investment you would select, if not both. Explain your answer.
Using Microsoft Excel, calculate the IRR for each investment.
Using the decision-making criteria for the IRR, specify which alternative you would prefer. Explain your answer.
If funding were available, specify whether you would select both investments. Why or why not?
Calculate the profitability index (PI) for the two investments. Which project is preferred?
Determine whether there is a ranking conflict present in terms of the IRR and the NPV. Explain your answer. If a conflict does exist, explain how you would resolve the situation.
Submission Details:
Compile a report including all your responses from Weeks 1, 3, and 5. Make sure your report reads as one report rather than three reports pasted together. Complete all revisions suggested by your instructor in previous weeks. Make sure all responses are complete and accurate, supported by references and documented examples. The report should be 10â15 pages in length and include an executive summary.
You are an economist for the Vanda-Laye Corporation, which produces and distributes outdoor cooking supplies. The company has come under new ownership and management and will be undergoing changes in its product lines and operating structure. As an economist, your responsibilities include examining the market factors that affect success or failure of a product, including the supply and demand for the product, market conditions, and the behavior of competitors with similar products.
The new management has identified several possible investments for the coming year. It has asked you and your team to evaluate the possibilities and make a recommendation to the board of directors. Jorge has identified two mutually exclusive opportunities (Investment A) and two independent opportunities (Investment B) and assigned you the task of making a recommendation on the investments.
Investment A
Your company would like to increase its product lines. Two alternatives are available, a new line of outdoor smokers and a new line of outdoor grills. The two lines are mutually exclusive, meaning that only one of these investment alternatives can be selected. The projected cash flows and their respective probabilities for each alternative are given in the table. There are three possible levels of demand and their corresponding probabilities, which depend on the state of the economy.
Click here to download the table for Investment A.
The two alternatives carry equal risk and should be evaluated at the company's cost of capital. The cost for the new smoker line will be $7,000,000. Also, the company has been guaranteed a buyer for the new line at the end of the fifth year. The buyer has agreed to purchase the new line for $7,900,000. The outdoor grill alternative will cost $3,987,000 and also has a guaranteed buyer, who has agreed to pay $4,000,000 at the end of the fifth year.
Investment B
Investment B involves two independent investment opportunities. The decisions on these two investment alternatives are also independent of Investment A. Investment B-1 involves a new packaging machine, which will eliminate the need for a local firm for packaging Vanda-Laye's products. The cost of this machine will be $24,000, and the expected revenues from this opportunity are given in the table and are considered to be of average risk. Investment B-2 is the purchase of a new computer system that will allow the company to sell its products on the Internet worldwide. The cost of this new system will be $29,000, with the expected cash flows after taxes given in the table.
Click here to download the table for Investment B.
Jorge has asked you to provide detailed responses to the following:
Management of Vanda-Laye has determined that the capital structure of the company will involve 30% debt and 70% common equity. This structure will be used to finance all investments by the company. Currently, the company can sell new bonds at par, with a coupon rate of 7%. Any new common stock can be sold for $45, with a required return (or cost) of 15.57%. Using Microsoft Excel, calculate the company's cost of capital to be used in the evaluation of possible investment projects.
For Investment A:
Using Microsoft Excel, create a decision tree. Indicate the various levels of demand and their respective probabilities. Also, include the calculations for the expected cash flows.
Calculate the expected NPV for each alternative. Explain the decision rules for making a selection between the two alternatives on the basis of the expected NPV.
Assuming the two alternatives are mutually exclusive, specify which alternative you would recommend to the company. Explain why.
If the two alternatives were independent of each other, specify which project you would select. Would you accept both projects if funding were available for both? Explain your answer.
For Investment B:
Using Microsoft Excel, calculate the NPV for each alternative.
Using the decision-making criteria for the NPV, specify which alternative you would select if the two alternatives were mutually exclusive. Explain your answer.
Given that the two alternatives are independent of each other, specify which investment you would select, if not both. Explain your answer.
Using Microsoft Excel, calculate the IRR for each investment.
Using the decision-making criteria for the IRR, specify which alternative you would prefer. Explain your answer.
If funding were available, specify whether you would select both investments. Why or why not?
Calculate the profitability index (PI) for the two investments. Which project is preferred?
Determine whether there is a ranking conflict present in terms of the IRR and the NPV. Explain your answer. If a conflict does exist, explain how you would resolve the situation.
Salvatore Chapter 1:
Discussion Questions: 9. How is the concept of a normal return on investment related to the distinction between business and economic profit?
Problems:
5. Determine which of the two investment projects a manager should choose if the discount rate of the firm is 10%. The first project promises a profit of $100,000 in each of the next 4 years, while the second project promises a profit of $75,000 in each of the next 6 years.
6. Determine which of the two investment projects of Problem 5 the manager should choose if the discount rate of the firm is 20%.
15. Integration Problem Samantha Roberts has a job as a pharmacist earning $30,000 per year, and she is deciding whether to take another job as the manager of another pharmacy for $40,000 per year or to purchase a pharmacy that generates a revenue of $200,000per year. To purchase the pharmacy, Samantha would have to use her $20,000 savings and borrow another $80,000 at an interest rate of 10% per year. The pharmacy that Samantha is contemplating purchasing has additional expenses of $80,000 for supplies, $40,000 for hired help, $10,000 for rent, and $5,000 for utilities. Assume that income and business taxes are zero and that the repayment of the principle of the loan does not start before 3 years. (a) What would be the business and economic profit if Samantha purchased the pharmacy? Should Samantha purchase the pharmacy? (b) Suppose that Samantha expects that another pharmacy will open nearby at the end of 3 years and that this will drive the economic profit of the pharmacy to zero. What would the revenue of the pharmacy be in 3 years? (c) What theory of profit would account for profits being earned by the pharmacy during the first 3 years of operation? (d) Suppose that Samantha expects to sell the pharmacy at the end of 3 years for $50,000 more than the price she paid for it and that she requires a 15% return on her investment. Should she still purchase the pharmacy?
Spreadsheet Problem (see attached Excel doc)
Using the data below, (Excel doc) where column A represents student numbers, column B the finishing time for a 1 mile race for 10 students, and column C the age of the students, (a) Use the data analysis tools to plot a line graph of all the finishing times. (b) Calculate a mean, median, mode, sample variance, sample standard deviation, and coefficient of variation to statistically describe the data. (c) Use Excel to fine the covariance between the two variables. What does the covariance indicate about the relationship between finishing time and age?
Note:
P15(d): Change â⦠for $50,000 more than â¦â to â⦠for $50,000 less than â¦â Compare the present value of economic profit in each of the next three years and the loss of $50,000 in the third year using 15% as the discount rate.
The spreadsheet problem (b): Calculate a mean, â¦. to statistically describe the data of both variables, Time and Age.
Individual problems:
3-1 You won a free ticket to see a Bruce Springsteen concert (assume the ticket has no resale value). U2 has a concert the same knight, and this represents your next-best alternative activity. Tickets to the U2 concert cost $80, and on any particular day, you would be willing to pay up to $100 to see this band. Assume that there are no additional costs of seeing either show. Based on the information presented, what is the opportunity cost of seeing Bruce Springsteen?
3-3 Because of the housing bubble, many houses are now selling for much less than their selling price just 2 to 3 years ago. There is evidence that homeowners with virtually identical houses tend to ask for more is they paid more for the house. What fallacy are they making?
Salvatore Chapter 3:
Discussion Questions:
9. How would you react to a sales managerâs announcement that he or she has in place a marketing program to maximize sales?
Problems:
1(a). Given the following total-revenue function: TR= 9Q - Q^2
Derive the total-, average-, and marginal- revenue schedules from Q=0 to Q=6 by 1âs.
7. Given the total-cost schedule: Q 0 1 2 3 4
TC 1 12 14 15 20
Derive the average- and marginal-cost schedules.
9. With the total-revenue curve of Problem 1 and the total-cost curve of problem 7, derive the total-profit function and show how the firm determines the profit-maximizing level of output.
Note:
DQ9: Does maximum sales (revenue) equal maximum profit (see figure 3-4)?
Revised P1(a): Derive the total-revenue, average-revenue, and marginal-revenue schedules from Q = 0 to Q = 4 by 1s.
Average revenue (AR) = total revenue (TR)/Q
Marginal revenue (MR) = change in total revenue/change in Q
For example:
Q | TR | AR | MR |
2 | 14 | 7 (=14/2) | |
3 | 18 | 6 (=18/3) | 4 (=(18-14)/(3-2) |
Revised P9: With the total-revenue schedule of Problem 1 and the total-cost schedule of Problem 7, show the profit-maximizing level of output (profit=TR-TC).
Froeb et al. Chapter 4:
Individual problems:
4-5 Your insurance firm processes claims through its newer, larger high-tech facility and its older, smaller low-tech facility. Each month, the high-tech facility handles 10,000 claims, incurs $100,000 in fixed costs and $100,000 in variable costs. Each month, the low-tech facility handles 2,000 claims, incurs $16,000 in fixed costs and $24,000 in variable costs. If you anticipate a decrease in the number of claims, where will you lay off workers?
4-6 A copier company wants to expand production. It currently has 20 workers who share eight copiers. Two months ago, the firm added two new copiers, and output increased by 100,000 pages per day. One month ago, they added five workers, and productivity also increased by 50,000 pages per day. Copiers cost about twice as much as workers. Would you recommend they hire another employee or buy another copier?