Questions and Exercises

1. You have been given the following information on a project:

• The initial investment in the project will be $25 million, and the investment will be depreciated straight line, down to a salvage value of $10 million at the end of the fifth year.

• The revenues are expected to be $20 million next year and to grow 10% a year after that for the remaining 4 years.

• The cost of goods sold, excluding depreciation, is expected to be 50% of revenues.

a. Estimate the pre-tax return on capital, by year and on average, for the project.

b. Estimate the after-tax return on capital, by year and on average, for the project.

c. If the firm faced a cost of capital of 12%, should it take this project.

2. Now assume that the facts in problem 1 remain unchanged except for the depreciation method, which is switched to an accelerated method with the following depreciation schedule:

Year % of Depreciable Asset

Depreciable Asset = Initial Investment - Salvage Value a. Estimate the pre-tax return on capital, by year and on average, for the project.

b. Estimate the after-tax return on capital, by year and on average, for the project.

c. If the firm faced a cost of capital of 12%, should it take this project?

3. Consider again the project described in problem 1 (assume that the depreciation reverts to straight line). Assume that 40% of the initial investment for the project will be financed with debt, with an annual interest rate of 10% and a balloon payment of the principal at the end of the fifth year.

a. Estimate the return on equity, by year and on average, for this project.

b. If the cost of equity is 15%, should the firm take this project?

4. Answer true or false to the following statements:

a. The return on equity for a project will always be higher than the return on capital on the same project.

b. If the return on capital is less than the cost of equity, the project should be rejected.

c. Projects with high financial leverage will have higher interest expenses and lower net income than projects with low financial leverage and thus end up with a lower return on equity.

d. Increasing the depreciation on an asset will increase the estimated return on capital and equity on the project.

e. The average return on equity on a project over its lifetime will increase if we switch from straight line to double declining balance depreciation.

5. Under what conditions will the return on equity on a project be equal to the internal rate of return, estimated from cashflows to equity investors, on the same project?

6. You are provided with the projected income statements for a project: Year 12 3 4

• The project required an initial investment of $15,000 and an additional investment of $2,000 at the end of year 2.

• The working capital is anticipated to be 10% of revenues, and the working capital investment has to be made at the beginning of each period.

a. Estimate the free cash flow to the firm for each of the 4 years.

b. Estimate the payback period for investors in the firm.

c. Estimate the net present value to investors in the firm, if the cost of capital is 12%. Would you accept the project?

Revenues

- Cost of Goods Sold

- Depreciation

d. Estimate the internal rate of return to investors in the firm. Would you accept the project?

7. Consider the project described in problem 6. Assume that the firm plans to finance 40% of its net capital expenditure and working capital needs with debt.

a. Estimate the free cash flow to equity for each of the 4 years.

b. Estimate the payback period for equity investors in the firm.

c. Estimate the net present value to equity investors if the cost of equity is 16%. Would you accept the project?

d. Estimate the internal rate of return to equity investors in the firm. Would you accept the project?

8. You are provided with the following cash flows on a project:

Year Cash Flow to Firm

Plot the net present value profile for this project. What is the internal rate of return? If this firm had a cost of capital of 10% and a cost of equity of 15%, would you accept this project?

9. You have estimated the following cash flows on a project:

Year Cashflow to Equity

Plot the net present value profile for this project. What is the internal rate of return? If the cost of equity is 16%, would you accept this project?

10. Estimate the modified internal rate of return for the project described in problem 8. Does it change your decision on accepting this project?

11. You are analyzing two mutually exclusive projects with the following cash flows:

Year

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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