January-February 2007

Corporate Finance I
Home assignment 2
Due by January 30
Problem 1. IRR and NPV.
Project A involves an investment of $1 million, and project B involves an investment of $2
million. Both projects have the same unique (in the interval from 0 to ) internal rate of return of
20%.
a) Assume that both projects have positive cash flows in any period and that project Bs cash
flow is twice as large as that of project A in any period. Rank the two projects according to the NPV
criterion for all values of the discount rate from 0 to .
b) Does the ranking obtained in a) hold when the assumptions of a) are dropped? Prove your
answer.
Problem 2. Project Selection with Resource Constraints.
A company is evaluating several development projects for experimental drugs. The company has
come up with the following estimates of the initial capital requirements and NPVs for the projects.
The company has also estimated the number of research scientists required for each development
project (all cost values are given in millions of dollars)
Project
number
I
II
III
IV
V

Initial
capital
$10
15
15
20
30

Number of
research scientists
2
3
4
3
10

NPV
10
19
22
30
60

a) Suppose that the company has a total capital budget of $60 million and no constraints on the
number of scientists. Which projects should it select?
b) Suppose that the company currently has only 12 scientists and cannot hire any more, while
there are no constraints on capital. Which projects should it select?
c) Do answers in a) and b) coincide with the answers you would get if you simply ranked the
projects according to their profitability index and selected projects consecutively starting
from the one with the highest PI until the resource constraint becomes violated?

Problem 3. Replacement.
Pilot Plus Pens is considering when to replace its old machine. The replacement costs $3 million
now and requires maintenance costs of $500,000 at the end of each year during the economic life of
five years. At the end of five years the new machine would have a salvage value of $500,000. It will
be fully depreciated by the straight-line method. The corporate tax rate is 34 percent and the
appropriate discount rate is 12 percent. Maintenance cost, salvage value, depreciation, and book
value of the existing machine are given as follows.
Book Value
Year Maintenance Salvage
Depreciation
(end of year)
0
$ 400,000
$2,000,000
$200,000
$1,000,000
1
1,500,000
1,200,000
200,000
800,000
2
1,500,000
800,000
200,000
600,000
3
2,000,000
600,000
200,000
400,000
4
2,000,000
400,000
200,000
200,000
The company is assumed to earn a sufficient amount of revenues to generate tax shields from
depreciation. When should the company replace the machine?
Problem 4. Project Evaluation (Please, use Excel to solve this problem)
Billingham Packaging is considering expanding its production capacity by purchasing a new
machine, the XC-750. The cost of the XC-750 is $2.75 million. Unfortunately, installing this
machine will take several months and will partially disrupt production. The firm has just completed a
$50,000 feasibility study to analyze the decision to buy the XC-750, resulting in the following
estimates:
Marketing: Once the XC-750 is operating next year, the extra capacity is expected to generate
$10 million per year in additional sales, which will continue for the ten-year life of the machine.
Operations: The disruption caused by the installation will decrease sales of other Billinghams
products by $5 million this year (only this year, there are no negative effects of XC-750 in future
years). As with Billinghams existing products, the cost of goods for the products produced by the
XC-750 is expected to be 70% of their sale price. The increased production will also require
increased inventory on hand of $1 million during the life of the project.
Human Resources: The expansion will require additional sales and administrative personnel at a
cost of $2 million per year.
Accounting: The XC-750 will be depreciated via the straight-line method over the ten-year life of
the machine. The firm expects receivables from the new sales to be 15% of revenues and payables to
be 10% of the cost of goods sold. Billinghams marginal corporate tax rate is 35%.
Additional assumption: Receivables and payables related to other Billinghams products are also
15% of revenues and 10% of cost of goods sold. Hence, first year disruption of production also
decreases those receivables and payables this year. We assume, however, that it does not change
inventory related to other Billinghams products.
a) Determine the incremental earnings from the purchase of the XC-750.
b) Determine the free cash flow from the purchase of the XC-750.
c) If the appropriate cost of capital for the expansion is 10%, compute the NPV of the purchase.
d) While the expected new sales will be $10 million per year from the expansion, estimates
range from $8 million to $12 million. What is the NPV in the worst case? In the best case?
e) What is the break-even level of new sales from the expansion? What is the break-even level
for the cost of goods sold?
f) Billingham could instead purchase the XC-900, which offers even greater capacity. The cost
of the XC-900 is $4 million. The extra capacity would not be useful in the first two years of
operation, but would allow for additional sales in years 310. What level of additional sales
(above the $10 million expected for the XC-750) per year in those years would justify
purchasing the larger machine?