FNCE10002 Lecture Notes - Lecture 5: Sunk Costs, Tax Shield, Net Present Value

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tealcattle862

7 Oct 2018

School

University of Melbourne

Department

Finance

Course

FNCE10002

Professor

Howard

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Document Summary

Melbourne and london offices: decision rule for independent projects. Ignores the time value of money: hurdle is arbitrary. Allocated costs: some costs may be common to several activities, e. g. Npv calculation: but sometimes they can be incremental and in these cases should be included in an. A manager may reject a project with a positive npv because it will increase the costs allocated to the division. It"s a(cid:271)out ho(cid:449) to a(cid:374)al(cid:455)se the(cid:373) (cid:272)orre(cid:272)tl(cid:455: the discount rate used represents the rate of return required by equity holders, debtholders and other securityholders. In principle, it makes no difference which approach we use: we get the same result, a project has only one npv, although different analysts will usually have different estimates of this one number. In practice, first method is nearly always easier. Inflation, nominal rates and real rates: the formula is: (cid:1863)=(cid:4666)(cid:883)+(cid:1863) (cid:4667)(cid:4666)(cid:883)+(cid:1868)(cid:4667) (cid:883)

Related Questions

Understanding the NPV Profile

1. If an independent project with conventional, or normal cash flows is being analyzed, the net present value (NPV) & internal rate of return (IRR) methods _______ agree.

A. Always

B. Never

C. Sometime

Projects W & X are mutually exclusive projects. Their cash flows & NPV profiles are shown as follows:

Year	Project W	Project X
0	$-1,500	$-1,500
1	$200	$900
2	$350	$600
3	$600	$300
4	$1000	$200

2. If the required rate of return for each project is 2%, do the NPV & IRR methods agree or conflict?

A. The methods agree

B. The methods conflict

A Key to resolving this conflict is the assumed reinvestment rate.

3. The NPV calculation implicitly assumes that intermediate cash flows are reinvested at the?

A. Modified rate of return (MIRR)

B. Required rate of return

C. Internal rate of return (IRR)

4. The IRR calculation assumes that the rate at which cash flows can be reinvested is the?

A. Modified rate of return (MIRR)

B. Required rate of return

C. Internal rate of return (IRR)

5. As a result, when evaluating mutually exclusives projects, the ________ is usually the better decision criterion.

A. IRR method

B. NPV method

Jackson Resources is evaluating 4 major projects which have either two or three year lives. The company has raised all of its capital in the form of equity and has never borrowed money. This is partly due to the success of the business in generating income and partly due to an insistence by the dominant managing director that borrowing is to be avoided if at all possible. Shareholders in Jackson resources regard the company as relatively risky, given its existing portfolio of projects. Other company's share in this risk class have generally given a return of 16% per annum and this is taken as the opportunity cost of capital for the investment projects. The risk level for the proposed projects is the same as that of the existing range of activities.

	Years
Projects (Dollars)	T0	T1	T2	T3
A	-5266	2500	2500	2500
B	-8000	0	0	10000
C	-2100	200	2900	0
D	-1975	1600	800	0

Ignore taxation and inflation.

1.1 The managing diretor has been on a one-day intensive course to learn about project appraisal techniques. Unfortunately, during the one slot given over to NPV he had to leave the room to deal with a business crisis, and therefore does not understand it. He vaguely understands IRR and insists that you use this to calculate which of the 4 projects should be proceeded with, if there are no limitations on the number which can be undertaken. (10 marks)

1.2 Sate which is the best project if they are mutually exclusive (i.e accepting one excludes the possibility of accepting others) using IRR. (3 marks)

1.3 Use the NPV decision rule to rank the projects and explain why, under conditions of mutual exclusivity, the selected project differs from that under (1.2 above)... (4 marks)

1.4 Write a report for the managing director, detailing the value of the net present value method for shareholder wealth enhancement and explaining why it may be considered of greater use than IRR. (8 marks)

tansea-lion662

In November of 2006, Toyota completed the building of its truck assembly plant in San Antonio, Texas. Unfortunately, in the rush to meet construction deadlines, Toyota instructed the general contractor to not install air conditioning (A/C) in the main facility. But now the time has come for Toyota to finish the facility with the installation of A/C. Toyota's contractor has developed two alternative plans (they are mutually exclusive) for the company to consider:

Plan 1: This A/C investment would require an initial outlay of $600,000 with the following end of year net cash flows: Year 1: -$50,000; Year 2: -$50,000; Year 3: -$50,000; Year 4: -$50,000, Year 5: -$50,000.

Plan 2: This alternative plan would require a smaller initial outlay but higher yearly operating costs. The initial outlay would be $100,000 and end of year net cash flows are estimated to be: Year 1: -$175,000; Year 2: -$175,000; Year 3: -$175,000, Year 4: -$175,000; Year 5: -$175,000.

Question 1: Calculate the NPV for each plan. Assume that Toyota's WACC is 7%. Use a financial calculator to answer this question and show your keystrokes. Check figures for Plan 1: Keystrokes using the HP12C NPV keys are CF0 = -$600,000, CFj = -$50,000, Nj = 5, i = 7, so NPV for plan 1 is -$805,009.87; or using TVM keys (n=5, i=7, PV=?, PMT=-$50,000, FV=0) = -$205,009.87 plus -$600,000 = -$805,009.87.

Question 2: For mutually exclusive projects, normally the rule is to accept only the project or plan with the highest positive NPV. However, Toyota is faced with a mandatory decision to accept either plan 1 or 2, neither of which generates positive net cash flows. Which plan should Toyota accept? Explain why.

Question 3: Explain why the IRR of either plan cannot be determined.

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FNCE10002 Lecture Notes - Lecture 5: Sunk Costs, Tax Shield, Net Present Value

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