Problem Set 3

1. You are considering purchasing a machine for $250,000 that produces 10,000 widgets a year.
Each widget will sell for $5 next year (in nominal terms). Costs of producing and selling each
widget will be $1 next year (in nominal terms). Both costs and prices are expected to grow at the
general rate of inflation of 3%. The machine will last for 7 years and will have a salvage value of
$25,000. The machine should be depreciated straight-line over 7 years to the salvage value of
$25,000. The real discount rate is 5% and the corporate tax rate is 34%. Should you purchase the
machine?

2. A project requires an initial investment in equipment of $100,000 and is expected to produce

sales revenue of $120,000 the first year; this revenue will increase by 10% per year over the next
two years. Manufacturing costs are estimated to be 70% of the sales. The project feasibility
study, which was done last year, cost $20,000. The asset can be depreciated according to the
three-year schedule, which allows depreciation of 33.33% at t=1, 44.45% at t=2, and 22.22% at
t=3. The corporate tax rate is 34%. The project requires an investment in working
capital. Specifically, at the beginning of the project, $10,000 of working capital is required;
thereafter, working capital is projected to be 10% of revenue. The investment in working capital
will be recovered at the end of the third year. At t=3, the company plans to sell the equipment for
$10,000. If the discount rate is 12%, should the investment be undertaken?

3. A bottling company recently installed a new bottling machine. The machine’s initial
cost is $2,000 and can be depreciated on a straight line basis to a zero salvage value in 5 years.
The machine’s per year fixed cost is $1,800, and its variable cost is $0.50 per unit. The selling
price per unit is $1.50. The corporate tax rate is 34% and the appropriate discount rate is 16%.
Determine the number of units that the company should sell such that the net present value of
installing the new machine is equal to zero.

4. Suppose that you are considering investing $1 million in a project that has two possible
outcomes. If things go well, you will earn $200,000 per year forever. If things go poorly, you
will lose $50,000 per year forever. Assume all cash flows are after tax. You believe there is a
50% chance that things will go well. If you have the option to abandon the project after 5 years,
what is the value of this option to abandon? The discount rate is 8%.