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Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed.

PROBLEM SET THREE (40 points)

Please complete the following problems.  Make sure you show your work.

 1.           Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed.  The machine has a tax life of 5 years, and it can be depreciated according to the following rates.  The firm expects to operate the machine for 4 years and then to sell it for $12,500.  If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

 

                                            Year                              Depreciation Rate

 

                                               1                                            0.20

 

                                               2                                            0.32

 

                                               3                                            0.19

 

                                               4                                            0.12

 

                                               5                                            0.11

 

                                               6                                            0.06

 

 

 

 2.           Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below.  The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office.  The equipment for the project would be depreciated by the straight-line method over the project’s 3-year life, after which it would be worth nothing and thus, it would have a zero salvage value.  No new working capital would be required, and revenues and other operating costs would be constant over the project’s 3-year life.  What is the project’s NPV?  (Hint: Cash flows are constant in Years 1-3.)

 

WACC                                                                                                                          10.0%

 

Opportunity cost                                                                                                        $100,000

 

Net equipment cost (depreciable basis)                                                                      $65,000

 

Straight-line deprec. rate for equipment                                                                    33.333%

 

Sales revenues, each year                                                                                        $123,000

 

Operating costs (excl. deprec.), each year                                                                  $25,000

 

Tax rate                                                                                                                            35%

 

  

 

3.            Thomson Media is considering some new equipment whose data are shown below.  The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down.  Also, some new working capital would be required, but it would be recovered at the end of the project’s life.  Revenues and other operating costs are expected to be constant over the project’s 3-year life.  What is the project’s NPV?

 

 WACC                                                                                                                          10.0%

 

Net investment in fixed assets (depreciable basis)                                                    $70,000

 

Required new working capital                                                                                   $10,000

 

Straight-line deprec. rate                                                                                          33.333%

 

Sales revenues, each year                                                                                          $75,000

 

Operating costs (excl. deprec.), each year                                                                 $30,000

 

Expected pretax salvage value                                                                                    $5,000

 

Tax rate                                                                                                                         35.0%

 

  

 

4.            The executives of GW Inc. are considering a project that has an upfront cost of $3 million.  This project is expected to produce a cash flow of $500,000 at the end of each of the next 5 years.

 

The cost of capital is 10%

 

If GW goes ahead with the project today, it will obtain knowledge that will give rise to additional opportunities 5 years from today.

 

The company can decide at t=5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t=5.   There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of -$6 million. GW does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is.   However, the company cannot pursue the future opportunity unless it makes the $3 million investment today at t=0. What is the estimated net Present value of the project, after consideration of the potential future opportunity?

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