Additional Problems

to accompany

Introducing Corporate Finance

Prepared by

Michelle Goyan

John Wiley & Sons Australia, Ltd

CHAPTER 8 THE FIRST INVESTMENT GOAL HOME OWNERSHIP

PROBLEM 1 Daft Girlie Ltd operates a chain of 179 fashion stores nation wide. Sales last year were $400 million and cost of goods sold (not including depreciation) is 65% of sales. The selling and advertising expenses of the firm are $125 000 per annum. Threequarters of this expense is fixed. The remainder of the cost is shared equally among the stores. The corporate tax rate is 30%. The company is considering opening a new store that will cost $1.5 million to establish. The establishment costs would be depreciated straight line over an effective life of 8 years. Assume the new store will have the same costs as existing stores and that sales will be the same as those for the average existing store. Estimate the after-tax cash flows for the first 9 years of operation for the new store. Round your calculations for each variable to the nearest whole dollar.

PROBLEM 2 Minx Ltd is evaluating a project to manufacture faux fur. The equipment and set-up costs for the project will total $2.1 million. The equipment will be depreciated straight line over a seven year effective life Sales of $900 000 per annum are expected and cash operating costs will be 30% of sales. The project will run for 7 years and will have a zero salvage value. The corporate tax rate is 30%. The marginal shareholder of Minx is a foreign investor and the after-tax required return is 13% a) b) Estimate the relevant cash flows and the NPV for the project. Assume that Minx is currently losing money on another major project. It does not expect to have a taxable income for the first 3 years of the faux fur project. Estimate the relevant cash flows and NPV of the project under these circumstances. Is your recommendation on the project different under this scenario?

PROBLEM 3 You have decided to cash in on the fitness craze in your town, so you are thinking about setting up a gym. You can rent a warehouse close to the business district for $26 000 p.a. In order to attract the right sort of clientele, you will need to spend $70 000 on redecorating and installing mirrors on all surfaces. You will also purchase some equipment at a cost of $50 000. Both of these outlays can be depreciated straight line over a 4 year effective life. You expect that the equipment can be sold at the end of four years for $5000. Your market research suggests you can attract and maintain 450 members. Each would pay an annual membership fee of $650. Instructors are usually paid a salary of $35 000 pa and you would employ 4 of these to keep the gym operating 7 days a week. Your marginal tax rate is 47% and you will operate the business for 4 years before retiring. If your cost of capital is 16%, should you set up the business?

PROBLEM 4 You have been asked to evaluate a proposal for the owner of Bamboo Traders. The owners marginal tax rate is 47%. She has given you the following information about the project: it has a 5 year lifetime the installed cost of the project will be $250 000 the tax office gives this type of asset an effective life of 4 years the asset will be sold at the end of the project for an estimated $20 000 sales of $90 000 are expected in the first year of the project sales will grow at a rate of 5% pa for each year of the project cost of goods sold (excluding depreciation) is expected to be 30% of sales the owners required return is 8% Advise the owner of Bamboo Traders on the acceptability of the project. Round each calculation to the nearest dollar.

PROBLEM 5 How would your answer to Problem 4 change if the owner of Bamboo Traders chose to use the declining balance method of depreciation? Assume that any tax losses from this project can be used to offset tax payable in on other projects in the current year. Show calculations to support your answer, rounding each calculation to the nearest dollar.

PROBLEM 6 Arkwright & Sons is a partnership where the partners all have a marginal tax rate of 38%. They would like you to evaluate a project for them and have provided the following details: Revenue Cost of goods sold Depreciation Earnings before tax a) b) c) d) Year 1 Year 2 Year 3 Year 4 110 000 115 000 120 000 90 000 12 100 12 650 13 200 9 900 50 000 45 000 40 000 35 000 27 900 37 350 46 800 25 100

The initial investment in the project is $200 000 and an additional investment of $10 000 is required at the end of year 2. The asset purchased at the commencement of the project will be sold at the end of the project for its book value. Working capital will be 9% of revenues for each year. The working capital investment has to be made at the start of each period. All working capital will be recovered. The required return of the partners is 10%. estimate the relevant cash flows for the project estimate the payback period calculate the accounting rate of return calculate the NPV for the project

PROBLEM 7 You have been asked to recommend the best of three mutually projects. The cost of capital is 10%. Each project has a two year life and the cash flows are as follows: t=0 -150 000 60 000 -25 000 Year 1 90 000 60 000 15 000 Year 2 90 000 -90 000 15 000

Red project Blue project Green project

If you do not have a financial calculator, you can calculate the IRR in Excel using the =IRR(values, guess) function. a) recommend which project should be adopted b) explain how you chose between NPV and IRR as your tool of analysis

PROBLEM 8 Muttaburra Ltd have forecast the profits for the proposed Saurus project as follows: Profit year 1 17 298 year 2 23 157 year 3 29 016 year 4 15 562

The project will require an investment of $209 900 and will have a zero terminal value. Calculate the accounting rate of return.

PROBLEM 9 Daisy Chain Shoes is a small company that has limited access to funds. They currently have a capital rationing constraint of $500 000 and have asked you to recommend which investments they should make. Each investment can only be undertaken one time and more than one project will be undertaken. The proposed investments are: Initial investment $000 125 230 150 95 35 NPV $000 60 61 15 20 15

Project Stilettos Platforms Sling backs Creepers Thongs

The management of Daisy Chain will only raise the amount of funds required to invest in the set of projects that will maximise the owners wealth. a) Identify the wealth maximising set of projects from those available to Daisy Chain b) Advise on how much money Daisy Chain should raise?

PROBLEM 10 Your brother owns a rental property and needs to replace the hot water system. He has provided you with the following three alternatives:

A solar system which would cost $9000 to install and $200 annual operating costs. The system will last for 30 years and you can assume that the building will too. A gas system which would cost $3000 to install and $800 pa operating costs. This system would have a useful life of 15 years An electric system with a cost of $2500 to install and $1200 pa operating costs. This system would have a useful life of 12 years

a) If your brothers cost of capital is 12% and the hot water systems do not generate any tax benefits, which system would you recommend to maximise your brothers wealth? b) Are there any non-financial factors your brother might consider in his investment decision?

PROBLEM 11 Radar Ltd are considering two new projects and have asked that you do the evaluation. The management of Radar have supplied you with the following cash forecasts: t=0 Project I Project II 250 000 300 000 Year 1 120 000 120 000 Year 2 100 000 100 000 Year 3 90 000 90 000 80 000 70 000 Year 4 Year 5

Management estimate that Project I has a level of risk similar to that of most of the firms current projects. Project II is a new line of business for Radar, so is considered to have higher risk than average. Radars cost of capital is 12% and you have received the following risk-adjusted discount rates and categories: Risk category Low Medium High Discount rate (%) 10 12 16

Use the NPV or IRR method to evaluate the projects and advise Radar of your recommendation.