1

$ 5 million

$ 2 million

20%

a. Based upon the profitability index, which of these projects would you take?

b. Based upon the IRR, which of these projects would you take?

c. Why might the two approaches give you different answers?

16. You are the owner of a small hardware store and you are considering opening a gardening store in a vacant area in the back of the store. You estimate that it will cost you $ 50,000 to set up the store, and that you will generate $ 10,000 in after-tax cash flows from the store for the life of the store (which is expected to be 10 years). The one concern you have is that you have limited parking; by opening the gardening store you run the risk of not having enough parking for customers who shop at your hardware store. You estimate that the lost sales from such occurrence would amount to $ 3,000 a year, and that your after-tax operating margin on sales at the hardware store is 40%. If your discount rate is 14%, would you open the gardening store?

17. You are the manager of a grocery store and you are considering offering baby-sitting services to your customers. You estimate that the licensing and set up costs will amount to $150,000 initially and that you will be spending about $ 60,000 annually to provide the service. As a result of the service, you expect sales at the store which is $ 5 million currently to increase by 20%; your after-tax operating margin is 10%. If your cost of capital is 12%, and you expect the store to remain open for 10 years, would you offer the service?

18. You run a financial service firm where you replace your employee's computers every three years. You have 500 employees, and each computer costs $ 2,500 currently — the old computers can be sold for $ 500 each. The new computers are generally depreciated straight line over their 3-year lives to a salvage value of $ 500. A computer-service firm offers to lease you the computers and replace them for you at no cost, if you will pay a leasing fee of $ 5 million a year (which is tax deductible). If your tax rate is 40%, would you accept the offer?

19. You are examining the viability of a capital investment that your firm is interested in. The project will require an initial investment of $500,000 and the projected revenues are $400,000 a year for 5 years. The projected cost-of-goods-sold is 40% of revenues and the tax rate is 40%. The initial investment is primarily in plant and equipment and can be depreciated straight-line over 5 years (the salvage value is zero). The project makes use of other resources that your firm already owns:

(a) Two employees of the firm, each with a salary of $40,000 a year, who are currently employed by another division will be transferred to this project. The other division has no alternative use for them, but they are covered by a union contract which will prevent them from being fired for 3 years (during which they would be paid their current salary).

(b) The project will use excess capacity in the current packaging plant. While this excess capacity has no alternative use now, it is estimated that the firm will have to invest $ 250,000 in a new packaging plant in year 4 as a consequence of this project using up excess capacity (instead of year 8 as originally planned).

(c) The project will use a van currently owned by the firm. While the van is not currently being used, it can be rented out for $ 3000 a year for 5 years. The book value of the van is $10,000 and it is being depreciated straight line (with 5 years remaining for depreciation).

The discount rate to be used for this project is 10%.

a. What (if any) is the opportunity cost associated with using the two employees from another division?

b. What, if any, is the opportunity cost associated with the use of excess capacity of the packaging plant?

c. What, if any, is the opportunity cost associated with the use of the van ?

d. What is the after-tax operating cashflow each year on this project?

e. What is the net present value of this project?

20. Your company is considering producing a new product. You have a production facility that is currently used to only 50% of capacity, and you plan to use some of the excess capacity for the new product. The production facility cost $50 million 5 years ago when it was built and is being depreciated straight line over 25 years (in real dollars, assume that this cost will stay constant over time).

Product line_Capacity used Growth rate/year Revenues Fixed_Variable

_currently_currently Cost/Yr Cost/Yr

Old product 50% 5%/year 100 mil 25 mil 50 mil/yr

New product 30% 10%/year 80 mil 20 mil 44 mil/yr

The new product has a life of 10 years, the tax rate is 40%, and the appropriate discount rate (real) is 10%.

a. If you take on this project, when would you run out of capacity?

b. When you run out of capacity, what would you lose if you chose to cut back production (in present value after-tax dollars)? (You have to decide which product you are going to cut back production on.)

c. What would the opportunity cost to be assigned to this new product be if you chose to build a new facility when you run out of capacity instead of cutting back on production?

21. You are an analyst for a sporting goods corporation that is considering a new project that will take advantage of excess capacity in an existing plant. The plant has a capacity to produce 50000 tennis racquets, but only 25,000 are being produced currently though sales of the rackets are increasing 10% a year. You want to use some of the remaining capacity to manufacture 20,000 squash rackets each year for the next 10 years (which will use up 40% of the total capacity), and this market is assumed to be stable (no growth). An average tennis racquet sells for $100 and costs $40 to make. The tax rate for the corporation is 40%, and the discount rate is 10%. Is there an opportunity cost involved? If so, how much is it?

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