Corporate Finance 1
Problem Set for Lecture 4
1. You are a manager at Percolated Fiber, which is considering expanding its operations in
synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s
report on your desk, and complains, “We owe these consultants $1 million for this
report, and I am not sure their analysis makes sense. Before we spend the $25 million
on new equipment needed for this project, look it over and give me your opinion.” You
open the report and find the following estimates (in thousands of dollars):
All of the estimates in the report seem correct. You note that the consultants used
straight-line depreciation for the new equipment that will be purchased today (year 0),
which is what the accounting department recommended. The report concludes that
because the project will increase earnings by $4.875 million per year for 10 years, the
project is worth $48.75 million. You think back to your halcyon days in finance class
and realize there is more work to be done!
First, you note that the consultants have not factored in the fact that the project will
require $10 million in working capital upfront (year 0), which will be fully recovered
in year 10. Next, you see they have attributed $2 million of selling, general and
administrative expenses to the project, but you know that $1 million of this amount is
overhead that will be incurred even if the project is not accepted. Finally, you know
that accounting earnings are not the right thing to focus on!
a. Given the available information, what are the free cash flows in years 0 through 10
that should be used to evaluate the proposed project?
b. If the cost of capital for this project is 14%, what is your estimate of the value of
the new project?
2. Elmdale Enterprises is deciding whether to expand its production facilities. Although long-
term cash flows are difficult to estimate, management has projected the following cash
flows for the first two years (in millions of dollars):
a. What are the incremental earnings for this project for years 1 and 2?
b. What are the free cash flows for this project for the first two years?
3. A bicycle manufacturer currently produces 300,000 units a year and expects output levels to
remain steady in the future. It buys chains from an outside supplier at a price of $2 a
chain. The plant manager believes that it would be cheaper to make these chains rather
than buy them. Direct in-house production costs are estimated to be only $1.50 per
chain. The necessary machinery would cost $250,000 and would be obsolete after 10
years. This investment could be depreciated to zero for tax purposes using a 10-year
straight-line depreciation schedule. The plant manager estimates that the operation
would require additional working capital of $50,000 but argues that this sum can be
ignored since it is recoverable at the end of the 10 years. Expected proceeds from
scrapping the machinery after 10 years are $20,000.
If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%,
what is the net present value of the decision to produce the chains in-house instead of
purchasing them from the supplier?
4. You own a coal mining company and are considering opening a new mine. The mine itself
will cost $120 million to open. If this money is spent immediately, the mine will
generate $20 million for the next 10 years. After that, the coal will run out and the site
must be cleaned and maintained at environmental standards. The cleaning and
maintenance are expected to cost $2 million per year in perpetuity. If there are two IRRs
(r= 0.02924 and r= 0.08723) what does the IRR rule say about whether you should
accept this opportunity? If the cost of capital is 8%, what does the NPV rule say?