HW #3

Directions: Answer all the questions.
Please submit your work in Word or PDF formats only.
You can submit an Excel file to support calculations, but please “cut and paste” your solutions into the Word or PDF file. Be sure to show how you did your calculations. Also, please be sure to include your name at the top of the first page of your file. You can use any sources you wish, except for other people. Please be sure to document any source you use. 17
Please run spell check and proofread your answers.

Question #1

Consider the following potential investment, which has the same risk as the firm’s other projects:

Time Cash Flow
0 -$185,000
1 $32,000
2 $38,000
3 $38,000
4 $40,000
5 $40,000
6 $45,000
7 $46,000
  1. What are the investment’s payback period, IRR, and NPV, assuming the firm’s WACC is 9%.
  1. If the firm requires a payback period of less than 5 years, should this project be accepted? Be sure to justify your choice.
  1. Based on the IRR and NPV rules, should this project be accepted? Be sure to justify your choice.
  1. Which of the decision rules (payback, NPV, or IRR) do you think is the best rule for a firm to use when evaluating projects? Be sure to justify your choice.

Question #2

A firm believes it can generate an additional $260,000 per year in revenues for the next 5 years if it replaces existing equipment that is no longer usable with new equipment that costs $280,000. The firm expects to be able to sell the new equipment when it is finished using it (after 5 years) for $20,000. The existing equipment has a book value of $35,000 and a market value of $25,000. Variable costs are expected to total 70% of revenue. The additional sales will require an initial investment in net working capital of $26,000, which is expected to be recovered at the end of the project (after 5 years). Assume the firm uses straight line depreciation, its marginal tax rate is 35%, and its weighted-average cost of capital is 10%.

a) How much value will this new equipment create for the firm?

b) At what discount rate will this project break even?

c) Should the firm purchase the new equipment?
Be sure to justify your recommendation.

Question #3

Your company is interested in having a new facility constructed. The contractor expects that it will take approximately 3 years to complete the building. The contractor has offered you three payment plans for the building. They are as follows:

Time Plan 1 Plan 2 Plan 3
Today $300,000 $1,035,000 $950,000
1 year from now $1,300,000 $1,035,000 $0
2 years from now $1,300,000 $1,035,000 $1,600,000
3 years from now $1,300,000 $1,035,000 $1,600,000

The CFO of your company has asked you to provide recommendation concerning which payment plan to accept. What is your recommendation? Assume your weighted-average cost of capital is 10%.

Question #4

List and describe four “red flags” that may indicate you should consider revising your overhead allocation system.

Question #5

a) Describe the differences between unit-related, batch-related, and product-sustaining activities. Give one example of each type of activity.

b) Describe the difference between transaction drivers and duration drivers. When would one type be preferred over the other?