2.1.

CALCULATING PRESENT VALUES

Calculate the present value of each of the following cash flow streams, using a discount rate of 10%:
a. $500 received at the end of 5 years.
b. $500 received annually for each of the next 5 years.
c. $500 received annually for each of the next 50years.
d. $500 received annually for 100 years.

2.2. CALCULATING THE INTERNAL RATE OF RETURN

Singular Construction is evaluating whether to build a new distribution facility. The proposed investment will
cost Singular $4 million to construct and provide cash savings of $500,000 per year over the next 10 years.
a. What rate of return does the investment offer?
b. If Singular were to invest another $200,000 in the facility at the end of 5 years, it would extend the life of the
project for 4 years, during which time it would continue receiving cash savings of $500,000. What is the internal
rate of return for this investment?

2.3. CALCULATING PROJECT FCF

In the spring of 2010, Jemison Electric was considering an investment in a new distribution centre. Jemison’s
CFO anticipates additional earnings before interest and taxes (EBIT) of $100,000 for the first year of operation
of the centre in 2011, and, over the next five years, the firm estimates that this amount will grow at a rate of 5%
per year. The distribution centre will require an initial investment of $400,000 that will be depreciated over a
five-year period toward a zero salvage value using straight-line depreciation of $80,000 per year. Furthermore,
Jemison expects to invest an amount equal to the firm’s annual depreciation expense to maintain the physical
plant. These additional capital expenditures will also be depreciated over a period of five years toward a zero
salvage value. Jemison’s CFO estimates that the distribution centre will need additional net working capital
equal to 20% of new EBIT (i.e., the change in EBIT from year to year). Assuming the firm faces a 30% tax rate,
calculate the project’s annual project free cash flow (FCF) for each of the next five years.

2.6. COMPREHENSIVE PROJECT FCF TCM Petroleum is an integrated oil company head- quartered in Fort
Worth, Texas. Income statements for 2014 and 2015 are found below ($ millions):

  Dec-15 Dec-14
Sales 13368 12211
COGS -10591 -9755
Gross Profit 2777 2456
Selling and administrative expense -698 -704
Oper. Inc. before dep. 2079 1752
Dep. Depletion and amortalization -871 -794
Oper. Profit 1208 958
Int. Exp. -295 -265
Non. Oper. Inc or Exp. 151 139
Special iyems   20
Pretax Inc 1064 852
Taxes 425.6 340.8
Net Inc 638.4 511.2
In 2014, TCM made capital expenditures of $875 million, followed by $1,322 million in 2015. TCM also
invested an additional $102 million in net working capital in 2014, followed by a decrease in its investment in
net working capital of $430 million in 2015.
a. Calculate TCM’s FCF for 2014 and 2015. TCM’s tax rate is 40%.
b. Estimate TCM’s FCF for 2016–2020 using the following assumptions: Operating income continues to grow
at 10% per year over the next five years, CAPEX is expected to be $1,000 million per year, new investments in
net working capital are expected to be $100 million per year, and depreciation expense equals the prior year’s
total plus 10% of the prior year’s CAPEX. Note that because TCM is a going concern, we need not be
concerned about the liquidation value of the firm’s assets at the end of 2020.

2.8. INTRODUCTORY PROJECT VALUATION

South Tel Communications is considering the purchase of a new software management system. The system is
called B-Image, and it is expected to drastically reduce the amount of time that company technicians spend
installing new software. South Tel’s technicians currently spend 6,000 hours per year on installations, which
cost South Tel $25 per hour. The owners of the B-Image system claim that their soft- ware can reduce time on
task by at least 25%. The system requires an initial investment of $55,000 and an additional investment of
$10,000 for technician training on the new system. Annual upgrades will cost the firm $15,000 per year.
Because the investment is comprised of software, it can be fully expensed in the year of the expenditure (i.e., no
depreciation). South Tel faces a 30% tax rate and uses a 9% cost of capital to evaluate projects of this type.
a. Assuming that South Tel has sufficient taxable income from other projects so that it can immediately expense
the cost of the software, what are the free cash flows for the project for years zero through five?
b. Calculate the NPV and IRR for the project.

2.9. INTRODUCTORY PROJECT VALUATION

CT Computers Inc. is considering whether to begin offering customers the option to have their old personal
computers recycled when they purchase new systems. The recycling system would require CT to invest
$600,000 in the grinders and magnets used in the recycling process. The company estimates that for each system
it recycles, it would generate $1.50 in incremental revenues from the sale of scrap metal and plastics. The
machinery has a five-year useful life and will be depreciated using straight-line depreciation toward a zero
salvage value. CT estimates that in the first year of the recycling investment, it could recycle 100,000 PCs and
that this number will grow by 25% per year over the remaining four-year life of the recycling equipment. CT
uses a 15% discount rate to analyse capital expenditures and pays taxes equal to 30%.
a. What are the project cash flows? You can assume that the recycled PCs cost CT nothing.
b. Calculate the NPV and IRR for the recycling investment opportunity. Is the investment a good one based on
these cash flow estimates?
c. Is the investment still a good one if the Year1 units recycled are only 75,000?
d. Redo your analysis for a scenario in which CT incurs cost of $0.20 per unit to dispose of the toxic elements
from the recycled computers. What is your recommendation under these circumstances?

2.12. PROJECT VALUATION

Carson Electronics is currently considering whether or not to acquire a new materials-handling machine for its
manufacturing operations. The machine costs $760,000 and will be depreciated using straight-line depreciation
toward a zero salvage value over the next five years. During the life of the machine, no new capital expenditures
or investments in working capital will be required. The new handler is expected to save Carson $250,000 per
year before taxes of 30%. Carson’s CFO recently analysed the firm’s opportunity cost of capital and estimated it
to be 9%.
a. What are the annual free cash flows for the project?
b. What are the project’s net present value and internal rate of return? Is the project one that Carson should
accept? c. Carson’s new head of manufacturing was concerned about whether the new handler could deliver the
promised savings. In fact, he projected that the savings might be 20% lower than projected. What are the NPV
and IRR for the project under this scenario?