Richard Borton

BUS 5431
Homework Questions: Chapter Nine Problems 1, 3, 4, 5, 6 & 12

Sunday August 21, 2016

Problem 9-1: Present Value Analysis

James Hardy recently rejected a $20,000,000 five-year contract with the Vancouver Seals hockey team.
The contract offer called for an immediate signing bonus of $7,500,000 and annual payments of
$2,500,000. To Sweeten the deal, the president of player personnel for the Seals has now offered a
$22,000,000, five-year contract. This contract calls for annual increases and a balloon payment at the end
of five years.
Year 1 $2,500,000
Year 2 2,600,000
Year 3 2,700,000

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Year 4 2,800,000

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Year 5 2,900,000

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Year 5 balloon payment 8,500,000

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Total
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Suppose you are Hardy's agent and you wish to evaluate the two contracts using a required rate of return
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of 15 percent. In present value terms, how much better is the second contract?
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First Offer

Sign-on Year Payment

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0 $7,500,000
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1 2,500,000
2 2,500,000
3 2,500,000
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4 2,500,000
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5 2,500,000

IRR 15%
Total $15,880,387.75

Second Offer

Sign-on Year Payment

1 2,500,000
2 2,600,000
3 2,700,000
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 4 2,800,000
5 11,400,000

IRR 15%
Total $13,183,904.28

Problem 9-3: Choosing Among Alternative Investments

Albert Shoe Company is considering investing in one of two machines that attach heels to shoes. Machine
A costs $70,000 and is expected to save the company $20, 0000 per year for six years. Machine B costs
$95, 0000 and is expected to save the company $25,000 per year for six years. Determine the net present
value for each machine and decide which machine should be purchased if the required rate of return is
13 percent. Ignore taxes.

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First Deal

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Sign-on Year Payment

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Investment ($70,000)

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1 20,000
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20,000 Return on $9,951.00
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Investment
3 20,000
4 20,000
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5 20,000
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6 20,000
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IRR 13%
Total $79,951.00
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Second Deal
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Sign-on Year Payment

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Investment ($95,000)
1 25,000
2 25,000 Return on $4,938.74
Investment
3 25,000
4 25,000
5 25,000
6 25,000

IRR 13%
Total $99,938.74

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 Problem 9-4: Present Value and “What If” Analysis
National Cruise Line, Inc. is considering the acquisition of a new ship that will cost $200,000,000. In this
regard, the president of the company asked the CFO to analyze cash flows associated with operating the
ship under two alternative itineraries: Itinerary 1, Caribbean Winter/Alaska Summer and Itinerary 2,
Caribbean Winter/Eastern Canada
Summer. The CFO estimated the following cash flows, which are expected to apply to each of the next 15
years:

Caribbean/Alaska Caribbean/Eastern Canada

Net revenue $120,000,000 $105,000,000
Less:
Direct Program Expenses (25,000,000) (24,000,000)
Indirect program expenses (20,000,000) (20,000,000)

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Non-operating expenses (21,000,000) (21,000,000)

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Add back depreciation 115,000,000 115,000,000

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Cash flow per year $169,000,000 $155,000,000

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a.) For each of the itineraries, calculate the present values of the cash flows using required rates of
return of both 12% and 16% Assume a 15-year time horizon. Should the company purchase the
ship with either or both required rates of return?
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b.) The president is uncertain whether a 12 percent or a 16 percent required return is appropriate.
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Explain why, in the present circumstance, spending a great deal of time to determine the correct
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required return may not be necessary.

c.) Focusing on a 12 percent required rate of return, what would be the opportunity cost to the
company of using the ship in the Caribbean/Eastern Canada itinerary rather than a
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Caribbean/Alaska itinerary?
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a.) The returns for both the 12% and 16% are greater than the cost of the ship. This means that the NPV
of both options is positive and purchasing at either rate is recommended.
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Caribbean/Eastern
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Caribbean/Alaska
Canada
Net revenue $120,000,000 $105,000,000
Less:
Direct program expenses (25,000,000) (24,000,000)
Indirect program expenses (20,000,000) (20,000,000)
Non-operating expenses (21,000,000) (21,000,000)
Add back depreciation 115,000,000 115,000,000
Cash flow per year $169,000,000 $155,000,000

PV of Ship In Caribbean/Alaska Itinerary @ 12%

IRR 12% $1,151,036,099
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 Years 15

PV of Ship In Caribbean/Eastern Canada Itinerary @ 12%

IRR 12% $1,055,683,996 ($95,352,103)
Years 15

PV of Ship In Caribbean/Alaska Itinerary @ 16%

IRR 16% $864,195,705
Years 15

PV of Ship In Caribbean/Eastern Canada Itinerary @ 16%

IRR 16% $864,195,705 $0
Years 15

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b.) At 16%, both itineraries produce the same results. So either itinerary may be chosen. But at 12%, the

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Caribbean/Alaska itinerary produces the better result. So choosing the Caribbean/Alaska itinerary

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will produce the better results overall.

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c.) The opportunity cost of choosing the Caribbean/Alaska itinerary over the Caribbean/Canada

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itinerary at 12% would be the difference between the two present values, or $95,352,103.
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Problem 9-5: Net Present Value and Taxes
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Penguin Productions is evaluating a film project. The president of Penguin estimates that the film will
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cost $20,000,000 to produce. In the first year, the film is expected to generate $16,500,000 in net revenue,
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after which the film will be released to video, Video is expected to generate $10,000,000 in net revenue in
its first year, $2,500,000 in its second year and $1,000,000 in its third year. For tax purposes amortization
of the cost of the film will be $12,000,000 in year 1 and $8,000,000 in year 2. The company’s tax rate is 35
percent and the company requires a 12 percent rate of return on its films.
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What is the net present value of the film project? To simplify, assume that all outlays to produce the film
occur at time 0. Should the company Produce the film?
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The NPV is projected from the cash flows of the project. The NPV is positive. Therefore, the film should be
produced.

Year 0 1 2 3 4
Film's Cost ($20,000,000)
Revenue $16,500,000 $10,000,000 $2,500,000 $1,000,000
Amortization 12,000,000 8,000,000
Income Before
Taxes $4,500,000 $2,000,000 $2,500,000 $1,000,000
35% Taxes 1,575,000 700,000 875,000 350,000
Net Income 2,925,000 1,300,000 1,625,000 650,000
Operating Cash
Flow $14,925,000 $9,300,000 $1,625,000 $650,000
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 Total Cash Flow 14,925,000 9,300,000 1,625,000 650,000
NPV (@ 12%) $2,309,526

Problem 9-6: Internal Rate of Return and Taxes

The Boston Culinary Institute is evaluating a classroom remodeling project. The cost of the remodel will
be$350,000 and will be depreciated over 6 years using the straight-line method. The remodeled room will
accommodate 5 extra students per year. Each student pays annual tuition of $22,000. The before-tax
incremental cost of a student (e.g., the cost of food prepared and consumed by a student) is $2,000 per
year. The company's tax rate is 40% and the company requires a 12% rate of return on the remodeling
project.

Assuming a 6-year time horizon, what is the internal rate of return of the remodeling project? Should the
company invest in the remodel?

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Cash Flow Per Year:

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Revenue (5 Extra Students @ $22k) $110,000
Less Costs: (5 Students @ $2,000

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Each) 10,000
Depreciation: ($350,000 / 6) rs e 58,333
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Income Before Taxes $41,667
40% Taxes 16,667
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Net Income: 25,000

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Add Depreciation: 58,333

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Cash Flow: $83,333

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Annuity factor equals initial cost divided by cash flow = 350,000 / 83,333 = 4.20
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Cash Flow Per

Year (Excel)
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Cash Out ($350,000)

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Year 1 Cash Flow 83,333

Year 2 Cash Flow 83,333
Year 3 Cash Flow 83,333
Year 4 Cash Flow 83,333
Year 5 Cash Flow 83,333

Excel IRR: 6%

They should move forward with the investment because the IRR is greater than the cost of capital.

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 Problem 9-12: Comprehensive Capital Budgeting Problem
Van Doren Corporation is considering producing a new temperature regulator called Digidial.
Marketing data indicate that the company will be able to sell 45,000 units per year at $30. The product
will be produced in a section of an existing factory that is currently not in use.

To produce Digidial, Van Doren must buy a machine that costs $500,000. The machine has
an expected life of 6 years and will have an ending residual value of $15,000. Van Doren will depreciate
the machine over six years using the straight-line method for both tax and financial reporting purposes.

In addition to the cost of the machine, the company will incur incremental manufacturing costs of
$370,000 for component parts, $425,000 for direct labor, and $200,000 of miscellaneous costs. Also, the
company plans to spend $150,000 annually to advertise Digidial. Van Doren has a tax rate of 40 percent,
and the company’s required rate of return is 15 percent.

a.) Compute the NPV.

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b.) Compute the payback period.

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c.) Compute the accounting rate of return.

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d.) Should Van Doren make the investment required to produce Digidial?

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Cash Flows
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Revenue ($45,000 x 30) $1,350,000
Costs:
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Componenet Parts 370,000

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Direct Labor 425,000

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Misc. Costs 200,000

Advertising 150,000
Depreciation* 80,833
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Total Costs 1,225,833

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Income Before Taxes 124,167

40% Taxes 49,667
Net Income 74,500
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a.) Operating Cash Flow** $155,333

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 Depreciation = (initial cost – salvage value)/useful life = (500,000 – 15,000)/6 = $80,833

** Operating Cash Flow = Depreciation – Net Income

Cash Flows
Year Cash Flow PV factor Note PV of cash flows
0 Cost of machine (500,000) 1 (500,000)
1-6 Annual Cash Flow 155,333 3.7845 1 587,858
6 Salvage value 15,000 0.4323 2 6,485
Net Present Value 94,342

1.) 3.7845: Table B9-2. 6 Years @ 15%

2.) 0.4323: Table B9-1. 6 Years @ 15%
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 b.) Payback period = Initial Investment / Annual Cash Flow
$500,000 / $155,333 = 3.22 Years

c.) Accounting Rate of Return = Average Income / Average Investment

($74,500) / ($500,000/2) = $74,500 / $250,000 = 0.298 (100) = 29.80%

d.) The NPV of the project is positive, so the investment should be made.

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