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Intermediate

(continued)

Challenge

(Questions 20-22)

a. Assuming Hand Clapper operates this project for four years, what is the NPV?

b. Now compute the project NPV assuming the project is abandoned after only one year, after two years, and after three years. What economic life for this project maximizes its value to the firm? What does this problem tell you about not considering abandonment possibilities when evaluating projects?

22. Replacement Decisions Suppose we are thinking about replacing an old computer with a new one. The old one cost us $300,000; the new one will cost $600,000. The new machine will be depreciated straight-line to zero over its five-year life. It will probably be worth about $75,000 after five years.

The old computer is being depreciated at a rate of $100,000 per year. It will be completely written off in three years. If we don't replace it now, we will have to replace it in two years. We can sell it now for $120,000; in two years, it will probably be worth half that. The new machine will save us $130,000 per year in operating costs. The tax rate is 38 percent and the discount rate is 14 percent. a. Suppose we only consider whether or not we should replace the old computer now without worrying about what's going to happen in two years. What are the relevant cash flows? Should we replace it or not? Hint: Consider the net change in the firm's aftertax cash flows if we do the replacement.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

14. Options and Corporate Finance

© The McGraw-Hill Companies, 2002

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