Shapiro CapBgt IM

Chapter 2: Capital-Budgeting Principles and Techniques

QUESTIONS
1. a. What is the relationship between accounting income and economic profit?
Answer: Accounting income is calculated by taking revenues and subtracting all cash and non-
cash expenses (such as depreciation). Accounting income also often recognizes losses for tax
purposes as well, even though the economic loss may have taken place at another time.
Economic profit is the sum of the present values of all the cash flows net of expenses generated by
the firm’s actions. Economic profit measures true increments to value, but is hard to measure.
Accounting profit is correlated with economic profit, but not perfectly so. Accounting profit can
be measured much more easily.
b. What is the relationship between accounting rate of return and economic rate of return?
Answer: The accounting rate of return is the ratio of after-tax profit to average book investment.
Economic rate of return is the ratio of after-tax economic profit to the market value of the
investment. Economic profit equals cash accruals to the asset combined with changes in its
market value.
2. In 1991, AT&T laid a transatlantic fiber optic cable costing $400 million that can handle
80,000 calls simultaneously. What is the payback on this investment if AT&T uses just half its
capacity while netting one cent per minute on calls?
Answer: $210 Million per year assuming the half capacity is for 24 hours a day, 365 days per
year. The annual payback is then 53%.
3. The satisfied owner of a new $15,000 car can be expected to buy another ten cars from the
same company over the next 30 years (an average of one every three years) at an average
price of $15,000 (ignore the effects of inflation). If the net profit margin on these cars is 20
percent, how much should an auto manufacturer be willing to spend to keep its customers
satisfied? Assume a 9 percent discount rate.
Answer: At a 20 percent profit margin, the auto company will earn an annuity of about $3,000
every three years for the next 30 years. Discounted at 9 percent, this annuity is worth $9,402,
assuming that the first new car is purchased three years from today. Hence, an investment to keep
customers satisfied will have a positive NPV as long as the amount spent is less than $9,402.
Thus, a car company should be willing to spend up to $9,402 in present value terms to keep its
customers satisfied. A trick is available to calculate the present value of this annuity. Recognize
that an annuity received every three years for 30 years and discounted at 9 percent is equivalent to
a 10-year annuity discounted at 29.5029 percent since each cash flow term is discounted at
(1.09)3 = 1.295029.
4. Demonstrate that the following project has internal rates of return of 0 percent, 100 percent,
and 200 percent.
Year 1 2 3 4
Cash flow –$1,200 +7,200 –13,200 +7,200
Answer: To demonstrate that an IRR calculation is valid, compute the net present value at the
IRR. A valid IRR yields NPV = 0.
Year Cash Flow PV@0% PV@100% PV@200%
1 -1,200 -1,200 -600 -400.00
2 +7,200 +7,200 +1,800 +800.00
3 -13,200 -13,200 -1,650 -488.89
4 +7,200 +7,200 +450 +88.89
Total 0 0 0 0
5. During 1990, Dow Chemical generated the following returns on investment in its different
business units:
Business Unit Return on Investment (%)

Plastics 16.6
Chemicals/Performance Products 16.7
Consumer Specialties 12.7
Hydrocarbons/Energy 5.2
Other 1.6
Dow Chemical overall 11.8
Given these returns, which of the business units should Dow invest additional capital in? What
additional information would you need in order to make that decision?
Answer: These figures tell you what Dow earned in 1990. In order to decide on future
investments, you need the following information:
1. Whether these returns are representative of those expected to be earned in the

future in these different divisions. What matters for investment decisionmaking are
projected future returns, not past returns. To the extent that these returns vary widely from
year to year—which they do in the chemical business—historical return data for one year
are meaningless. One reason these data may be misleading is that they are based on
historical cost figures for investment. You really want to calculate returns on the
replacement cost of assets. Inflation will cause asset values to be understated, which will
lead the return on investment to be overstated.
2. The cost of capital for these divisions. Each division is likely to have its own risk
and, hence, its own cost of capital. A high return could just indicate a high degree of risk
and, therefore, a high required return. What matters is the projected return relative to the
cost of capital. A high projected return that is less than the risk-adjusted cost of capital will
yield a negative NPV investment. Conversely, a low projected return that exceeds the cost
of capital will yield a positive NPV investment.
3. The marginal return on investment in each division. Even if the figures for, say, the
plastics and chemical/performance products divisions exceed their cost of capital and are
representative of those expected to be earned in the future, that does not automatically
justify additional investment in those divisions. These figures tell us the average ROI; for
investment purposes you need the marginal ROI. That is, what matters for investment
purposes is not the return on past investments but the return on future investments. As we
have seen, many companies (e.g., Monsanto, Philip Morris) have divisions that yield high
returns on past investments but very low returns on incremental investments.
4. The extent to which these divisions sell to one another. Dow Chemical is a
vertically-integrated company. Its hydrocarbons/energy unit sells to its downstream
plastics unit, which in turn sells to its consumer specialties unit. Thus, the profitability of
these units depends critically on the prices at which these internal transactions take place.
For example, the hydrocarbons/energy unit may be showing a low ROI simply because it
sells petroleum to the plastics unit at a below-market price. That is, the hydrocarbons unit
may be very profitable but its profits are showing up in the plastics unit in the form of a
low price on raw materials. This is a form of cross-subsidization. Disentangling the true
profitability of the different units of a vertically-integrated company like Dow turns out to
be a very difficult task, but it is a necessary one for capital budgeting purposes. What
matters is how profitable investments are from the standpoint of the overall company, not
from the standpoint of the units undertaking those investments.
5. The returns associated with specific assets and activities within each division. What
matters from an investment standpoint is not just how well each division can be expected
to do in the future but how well specific projects within each division can be expected to
do. For example, certain products within the profitable plastics division may be earning a
40% return while others are only earning a 2% return. Similarly, certain R&D investments
may be expected to yield a high return relative to their riskiness, whereas others have little
chance of a significant payoff. At the same time, the low-return hydrocarbons/energy
division may have some very high-return projects, which are masked by a lot of
value-destroying activities elsewhere. Without detailed data on the returns associated with
each division’s various activities, customers, and products, one can’t say where investment
dollars would be best spent.
CHAPTER 2: PROBLEMS
1. A firm is considering investing in a project with the following cash flows:
Year 1 2 3 4 5 6 7 8
Net cash 2,00 3,00 4,00 3,50 3,00 2,00 1,00
1,000
flow ($) 0 0 0 0 0 0 0
The project requires an initial investment of $12,500, and the firm has a required rate of
return of 10 percent. Compute the payback, discounted payback, and net present value, and
determine whether the project should be accepted.
Answer: Payback period = 4 years exactly.
Discounted payback period (r = 10%) = 5.84 years.
Net Present Value (r = 10%) = $1164.70. The project should be accepted.
Intermediate Calculations:
Cash PV Cumulative
Cash Flows -12,500.00
1 2,000.00 1,818.18 1,818.18
2 3,000.00 2,479.34 4,297.52
3 4,000.00 3,005.26 7,302.78
4 3,500.00 2,390.55 9,693.33
5 3,000.00 1,862.76 11,556.09
6 2,000.00 1,128.95 12,685.04
7 1,000.00 513.16 13,198.20
8 1,000.00 466.51 13,664.70
2. The Pennco Oil Co. must decide whether it is financially feasible to open an oil well off the
coast of China. The drilling and rigging cost for the well is $5,000,000. The well is expected
to yield 585,000 barrels of oil a year at a net profit to Pennco of $5 a barrel for four years.
The well will then be effectively depleted but must be capped and secured at a cost of
$4,000,000. Pennco requires an annual rate of return of 14 percent on its investment
projects. Should Pennco open the well? (Assume all of a year’s production occurs at the end
of the year.)
Answer:
Net annual profit = 585,000($5.00) = $2.925M.
PV(Production) = $2.925M _ PVIFAr=14%,n=4 = 2.925M _ 2.9137 = $8.523M.
PV(Capping) = $4.000M _ PVIFr=14%,n=4 = 4 _ 0.5921 = $2.368M.
PV(Drilling) = $5.000M.
NPV = PV(Production) Ä PV(Capping) Ä PV(Drilling) = $8.523M Ä 2.368M Ä 5.000M =
$1.154M.
The well should be drilled, since the present value of the benefits exceeds the present value of the
costs. The term NPV (Net Present Value) refers precisely to the difference in present value
between the benefits and the costs of a project.
3. Jack Nicklaus, the golfing pro and real estate developer, is thinking of acquiring an 800- acre
property outside Atlanta that he intends to turn into an exclusive community for 600 families.
The cost of this property and the necessary improvements is $30 million. After setting aside a
mandatory 25 percent of the property as green space, he figures he can sell the remaining
lots for an average of $90,000 an acre. By putting in a golf course on the 200 acres of green
space, Nicklaus believes he can instead sell the lots for an average of $140,000 an acre. The
golf course, including clubhouse, has a projected price tag of $6 million. In either event, the
project is expected to take eight years to sell out at a rate of 75 lots per year. Jack Nicklaus
faces a marginal tax rate of 40 percent and can write off his land and development costs by
prorating these costs against each lot sold.
a. If his required return is 14 percent, should Jack Nicklaus go ahead with the initial
project (i.e., a community with no golf course)?
Answer: The initial project, a community with no golf course, requires an initial outlay of $30M,
and reaps 6.75M per year for 8 years in the absence of taxes and depreciation. The present value
of the decision at r = 14% and t = 40% can be determined from the following formula:
b. Should he put in the golf course?
Answer: With the golf course, the cost is $36M, and pretax revenues are 10.5M per year. The
same calculations as above can be made with the new data:
NPV = ─36,000,000 + (1 ─ 0.40)(10,500,000)(4.6389) + (0.40)(4,500,000)(4.6389) =

$1,574,797.54.
Nicklaus should build the golf course (exactly as we expected).

a.b. * An alternate display is illustrative:
Housing With Golf

Only Course
Annual Sales $6,750,000 $10,500,000
Ann. Amortization 3,750,000 4,500,000
Ann. Pretax Profit 3,000,000 6,000,000
Tax ( @ 40% ) 1,200,000 2,400,000
Ann. Aftertax Profit 1,800,000 3,600,000
Cash Flow 5,550,000 8,100,000
PVIFA(r=14%,n=8) 4.638864 4.638864
Present Value 25,745,695 37,574,798
Cost 30,000,000 36,000,000
Net Present Value ─$4,254,30 $1,574,798
5
4. The Coin Coalition is trying to get the U.S. government to replace the dollar bill with a gold-
colored dollar coin. One argument is cost savings. A dollar bill costs 2.6 cents to produce
and lasts only about 17 months. A dollar coin, on the other hand, while costing 6 cents to
produce, lasts for 30 years. About 1.8 billion dollar bills must be replaced each year. The
start-up costs of switching to a dollar coin are likely to be quite high, however. These costs
have not been estimated.
a. What are the projected average annual cost savings associated with switching from the
dollar bill to a dollar coin?
Answer: Since each dollar bill in circulation lasts an average of 1.42 years (17/12), and 1.8 billion
are replaced each year, this must mean that there are about 2.556 billion dollar bills in circulation.
The cost of replacing 1.8 billion dollar bills each year at a cost per bill of 2.6 cents is $46.8
million. Since the dollar coin lasts 30 years, only about 85.2 million (2.556 billion/30) coins must
be replaced each year at an annual cost of $5.1 million. Thus, the annual cost savings comes to
approximately $41.7 million.
b. Taking into account only the cost savings estimated in part a, how high can the start-up
costs for this replacement project be and still yield a positive NPV for the U.S. government?
Use an 8 percent discount rate.
Answer: The present value of the cost savings perpetuity estimated in part a, discounted at 8
percent, is $41,700,000/.08, or $521.25 million. Hence, the start-up costs for replacing the dollar
bill with a dollar coin can be as high as $521.25 million in present value terms and this project will
still yield a positive net present value.
5. Recent Census Bureau data show that the average income of a college-educated person was
$34,391 versus $24,701 for those without college. At the same time, the annual tuition at
public universities was $1,566 versus $7,693 for private colleges. In the following questions,
assume there is no difference in income between public and private university graduates.
a. Based on these figures, what is the payback period for a college education, taking into
account the four years of lost earnings while being in college? Do these calculations for
both public and private colleges.
Answer: Based on the figures presented, the lost income during four years of college is
4 * $24,701 = $98,804 (if they don’t go to college they earn non-college incomes). The cost of
the four years of college at a public (private) university is $6,264 ($30,772). Combining these
figures yields a total (undiscounted) cost for a public university of $105,068. For a private
college, this cost comes to $129,576. The income advantage to a college education is $9,690
($34,391 - $24,701). From graduation, it takes 105,068/9,690 = 10.84 years to recover the cost
of a public university education. The equivalent figure for a private college is 129,576/9,690 =
13.37 years.
b. Assuming college graduation at age 22 and retirement at age 65, what is the internal rate
of return on a college degree from a public university? a private university?
Answer: For a public university, the cash flows are four years of annual net cash outflows equal
to $26,267 ($1,566 + $24,701) and then 43 years of net cash inflows equal to $9,690 annually.
Whether all these cash flows occur at the beginning or end of the year, the IRR equals 7.89
percent (the timing of the cash flows doesn’t matter because you are just multiplying the NPV—
which must equal zero—by a constant).
For a private university, the cash flows are four years of annual net cash outflows equal to
$32,394 ($7,693 + $24,701) and then 43 years of net cash inflows equal to $9,690 annually. The
IRR based on these numbers is 6.32 percent.
c. Assuming a 7 percent discount rate, and the same working life as in part b, what is the net
present value of a college degree from a public university? a private university?
Answer: Assuming all cash flows occur at the end of the year (here the timing does matter), the
NPV for a public university education is $10,878. For a private college, the NPV is -$9,876.
6. The Fun Foods Corporation must decide on what new product lines to introduce next year.
After-tax cash flows are listed below along with initial investments. The firm’s cost of capital
is 12 percent and its target accounting rate of return is 20 percent. Assume straight-line
depreciation and an asset life of five years. The corporate tax rate is 35 percent. All projects
are independent.
Project Investment Year 1 2 3 4 5

A $5,000 $800 $1,000 $350 $1,250 $3,000
B 7,500 1,250 3,000 2,500 5,000 5,000
C 4,000 600 1,200 1,200 2,400 3,000
a. Calculate the accounting rate of return on the project. Which projects are acceptable
according to this criterion? (Note: Assume net income is equal to after-tax cash flow less
depreciation.)
Answer:
Project A Project B Project C

Total AT Cash Flow 6400 16750 8400
Total Depreciation 5000 7500 4000
Net Income 1400 9250 4400
Avg Net Income 280 1850 880
Acctg Rate of return (Average Net Income /Average Book Inv)

ABI = Total depreciation/2.
11.2% 49.3% 44%
Projects B and C are acceptable based on a 20% accounting rate of return.
b. Calculate the payback period. All projects with a payback of fewer than four years are
acceptable. Which are acceptable according to this criterion?
Answer: Assuming depreciation effects are included in the cash flows:

Payback A (years) = 4.53, Payback B = 3.15, Payback C = 3.42.
Projects B and C are acceptable.
Assuming depreciation has not been included:

Payback A (years) = 4.06, Payback B = 2.73, Payback C = 3.06.
c. Calculate the projects’ NPVs. Which are acceptable according to this criterion?
Answer: NPV = PV(After Tax Cash Flows) ─ Initial Investment

Assuming depreciation has already been incorporated:
NPV A = ─$742.72, NPV B = $3801.83, NPV C = $1574.01.
If depreciation has not been incorporated, and all writeoffs can be used:
NPV = PV(After Tax Cash Flows) ─ Init Inv + PV(Depr Tax Shield)
NPV A = $518.95, NPV B = $5694.34, NPV C = $2583.34.
All projects are acceptable.
d. Calculate the projects’ IRRs. Which are acceptable according to this criterion?
Answer: IRR is the discount rate that makes NPV = 0.

Depreciation included:
IRR A = 7.0%, IRR B = 27.0%, IRR C = 23.37%
Projects B and C are acceptable. (IRR > 12%)
Depreciation not included:

IRR A = 15.43%, IRR B = 34.23%, IRR C = 30.50%
All projects are acceptable. (IRR > 12%)
e. Which projects should be chosen?
Answer: The firm should follow the guidelines of the NPV rule.
7. Aptec, Inc., is negotiating with the U.S. Department of Housing and Urban Development
(HUD) to open a manufacturing plant in South Central L.A., the scene of much of the rioting
in April 1992. The proposed plant will cost $3.5 million and is projected to generate annual
after-tax profits of $550,000 million over its estimated four-year life. Depreciation is
straight-line over the four-year period and Aptec’s tax rate is 35 percent. However, given the
risks involved, Aptec is looking for a tax-exempt government subsidy. According to Aptec, the
subsidy must be able to achieve any of the following four objectives:
(1) Provide a 2-year payback.
(2) Provide an accounting rate of return of 35 percent.
(3) Raise the plant’s IRR to 22 percent.
(4) Provide an NPV of $1 million when cash flows are discounted at 18 percent.
a. For each alternative suggested by Aptec, develop a subsidy plan that minimizes the costs
to HUD of achieving Aptec’s objective. You can schedule the subsidy payments at any time
over the four- year period.
Answer. Here are the alternatives with their costs:

Payback. The annual cash flows are the sum of after-tax profits plus depreciation of $306,250
(0.35*$3,500,000/4), or $856,250. The sum of the first two years’ cash flows is $1,712,500. To
bring the payback to two years will require a subsidy of $1,787,500 ($3,500,000 - $1,712,500).
Since the computation of payback is insensitive to when the subsidy is paid, as long as it happens
within the two-year period, the present value of its cost can be minimized by providing it at the
end of year 2.
ARR. The accounting rate of return is 31.43% (550,000/1,750,000). In order to bring this up to
35%, it is necessary to bring average annual income up to $612,500 (0.35*1,750,000), an average
annual increase of 62,500. The subsidy will equal $250,000 (62,500*4). Since the computation of
ARR is insensitive to when the subsidy is received, its present value can be minimized by
providing it at the end of the four years.
IRR. With a subsidy of $1,365,000 at time 0, thereby lowering its net investment to $2,135,000,
Aptec will get its IRR up to 22%. Any delay will result in a correspondingly higher required
subsidy (it will accrue at the rate of 22% annually. For example, if the subsidy were to be provided
at the end of the first year, it would have to equal $1,665,300 ($1,365,000 ? 1.22) to get Aptec’s
IRR up to 22%. Hence, HUD will minimize its costs of getting Aptec’s IRR up to 22% by
providing the subsidy immediately instead of waiting.
NPV. The NPV of the project, discounted at 18%, is (1,196,635). Hence, a subsidy equal to
$1,196,635 that is paid up front will just provide a zero NPV when discounted at 18%. The
subsidy will rise at the rate of 18% annually if it is paid in a future year.
b. Which of the four subsidy plans would you recommend to HUD if it uses a 15 percent
discount rate?
Answer. The winning subsidy plan is that associated with the ARR criterion. By paying $250,000
at the end of the four-year period, the present value of HUD’s cost when discounted at 15% will
be $142,938.
8. The Fast Food chain is trying to introduce its new Hot and Spicy line of hamburgers. One
plan (S) will include a big media campaign but less in-house production capability. The
other plan (L) will concentrate on a more gradual roll-out of the project but will involve
more investment in personnel training and so forth. The cost of capital is 15 percent. The
cash flows ($000) are listed below. The initial investment for each is $400,000.
Plan Year 1 2 3 4 5
S $250 $250 $150 $100 $ 50
L 100 125 200 250 125
a. Construct the NPV profiles for plans S and L. Which has the higher IRR?
Answer: Plan S has NPV(000’s) = $187.09 and IRR = 39.28%, Plan L has NPV(000’s) =
$118.06 and IRR = 25.63%. Plan S has the higher IRR.
b. Which plan should Fast Food choose using the NPV method?
Answer: Plan S also has the higher NPV.
c. Which plan (S or L) should Fast Food choose? Why?
Answer: Under either criterion, Fast Food should choose Plan S.

d. At what cost of capital will the NPV and the IRR rankings conflict?
Answer: For this discount rate (15%), the NPV and IRR do not conflict. To find the discount
rate where a conflict might occur, calculate the discount rate that makes the present value of the
difference in cash flows zero. In this case, the cash flow differences are:
Year 1 2 3 4 5
Diff $150 $125 ─$50 ─$150 ─$75
Inspection reveals that the present value is zero when the discount rate is zero. NPV and IRR
give identical recommendations for all positive discount rates in this example.
9. The Roost Corp. is considering a multiple-use dockside complex in a major lakeside city.
Roost uses accounting rate of return as its sole capital-budgeting criterion. The sales and
expenses (excluding depreciation) are as follows ($000):
Year 1 2 3 4 5
Sales $800 $5,000 $15,000 $25,000 $25,000
Expenses 700 3,500 10,500 17,500 18,500
Investment in the project is $40 million today and the accelerated depreciation schedule applicable
to this project is
Year 1 2 3 4 5
15% 22% 21% 21% 21%
a. Should Roost accept the project using straight-line depreciation? Assume a target rate of
return of 15 percent. Its tax rate is 40 percent.
Answer: We assume that Roost Corp. has sufficient income to take full advantage of the tax
shields afforded by depreciation.
Year 1 2 3 4 5
After Tax Income 180 900 2700 4500 3900
SL Depr 8000 8000 8000 8000 8000
ACC Depr 6000 8800 8400 8400 8400
SL Net Cash Flow 3380 4100 5900 7700 7100
ACC Net Cash Fl 2580 4420 6060 7860 7260
Under straight-line average book value is the same, namely $20,000. Average after tax income is
$2556, and average annual depreciation is $8000. The accounting rate of return is (2556 ─
8000)/20,000 = ─27.22%. The project would be rejected on this basis.
b. Would your answer to (a) change if Roost used accelerated depreciation?
Answer: Accelerated depreciation results in the same numbers.
c. With a cost of capital of 10 percent, would the project have a positive NPV under
straight- line depreciation? Under accelerated depreciation?
Answer: With a cost of capital of 10%, the present value of the net cash flows under straight-line
depreciation is $20.56M. Under accelerated depreciation, the figure comes to $20.43M. Note
that “accelerated depreciation” does not improve the present value in this problem. Neither
method of depreciation justifies the $40M expense; the net present value is negative regardless of
the depreciation method chosen.
10. Sweet Delights Co. is considering a marketing policy for its brand of chocolates. Two
mutually exclusive advertising strategy changes are under consideration. The cash flows
associated with each are as follows. The cost of capital for Sweet Delights is 10 percent.
Strategy Year 0 1 2 3 4 5
-80 +40 +40 +40 - -
B -40 +20 +20 +20 +20 +20
a. Which of the two strategies would you prefer if neither decision can be repeated (i.e., all
future strategies/ decisions are expected to have zero NPVs)?
Answer: If neither decision can be repeated, then one should choose the strategy with the highest
NPV. For plans A and B, the NPV’s are 19.47 and 35.82, respectively. Therefore, plan B would
be preferred.
b. Which of the two strategies would you prefer if each strategy can be repeated as often as
possible?
Answer: If each strategy can be repeated as often as possible, one should calculate the equivalent
annual benefit derived from each of the proposals.
Equivalent Annual Benefit * PVIFA = NPV.
Plan A B
Summary 19.4 35.8
of NPV 7 2
Results: 3 5
Years
PVIFA 2.48 3.79
EAB 7.83 9.45
Plan B would be preferred in this instance as well.
CHAPTER 2: SPECIAL PROBLEM
1. Owen Corporation plans to purchase a new machine that costs $120,000, has six years of
economic life, and generates a net annual cash flow of $40,000 at the end of years 1-6 (all
cash flows have taken into account depreciation and taxes). The firm also has the option to
sell the machine at the end of years 1-6. The following are the net cash flows Owen will
receive from the sale of the machine at the end of each year.
End of Year Net Cash Flow From Sale
1 $100,000
2 85,000
3 75,000
4 60,000
5 30,000
6 0
The manager wants to determine an optimal replacement policy for the machine. Once a
policy has been adopted, it will be implemented perpetually because it is assumed that the
cost of the machine, the cash inflows, and the net cash flow from selling the old machines
will be the same over time. Determine the optimal policy, assuming a 12 percent discount
rate.
Answer: The optimal replacement policy for the machine requires that the machine be sold on the
date that maximizes the equivalent annual benefit derived from running the machine. For
example, if the machine is placed in service for 3 years only, the cash flows are:
Year 1 2 3
Cash Flow $40,000 $40,000 $40,000+75,000
= $115,000
With an initial investment of $120,000, the NPV at r=12% is given by $29,456.77. On an annual
basis, this represents a $12,264.30 benefit. This fact follows from the equation:
NPV = Equivalent Annual Benefit * PVIFA

The table below summarizes the results for all possible service lives:
Termination
NPV EAB
1 5,000.00 5,600.00
2 15,363.52 9,090.57
3 29,456.77 12,264.3
0
4 39,625.06 13,045.93*
5 41,213.8 11,433.12
5
6 44,456.2 10,812.91
9
The maximal equivalent annual benefit is realized when the machine is replaced every four years.
CHAPTER 3: QUESTIONS
1. A new investment project is to demolish an existing gas station and construct a small
shopping mall. Which of the items should be treated as incremental cash flows relevant to the
investment decision?
a. The current value of the land.
b. The current value of the gasoline- retailing business.
c. The cost of wrecking the gas station, digging up the tanks, and cleaning the land.
d. The cost of new antipollution devices installed by order of the local government six
months ago.
e. Lost earnings on other real estate projects owing to staff time that will be spent if the
mall is built.
f. An allocated portion of the depreciation from the company’s headquarters building.
g. The fee that has already been paid to an architect for designing the mall.
h. Future noncash expenses such as depreciation that will result if the mall is built. i.
Allocation of corporate overhead to the project.
Answer: The incremental cash flows relevant to the decision include items a, b, c, e, and h. The
current value of the land (a) is used by both the gas station and the mall. However, the land may
be sold; therefore, its value is incremental (as an opportunity cost). Items (d) and (g) are sunk
costs. Items (f) and (i) represent suspicious allocations of corporate overhead to the mini-mall
project.
In effect, the owner must examine the following three alternatives and select the one with the
maximum value:
i) Keep the gasoline business and either continue to operate it or sell it to someone else.
ii) Tear the gasoline station down and selling the land.
iii) Tear the gasoline station down and put up the shopping mall.
2. A soft drink bottler is trying to determine the present value of its business in an area where it
forecasts no growth in unit sales. Sales this year will be $10 million and expenses will be $9
Chapter 3: Estimating Project Cash Flows
million. The present rate of return required is 20 percent, and inflation is expected to be 10
percent indefinitely.
The company president believes that the present value of the business is $5 million, that is,
$1 million per year discounted at 20 percent. His assistant argues that the present value is $1
million divided by 10 percent, the expected real interest rate. This yields an NPV of $10
million. What is the correct solution to the valuation problem?
Answer: We interpret the phrase “no growth” to refer to lack of unit sales growth. The price of
soft drinks and the corresponding expenses are assumed to grow at the average rate of inflation.
The assistant is correct; real cash flows should be discounted at real interest rates. We expect to
have $1M in earnings in the next year. In real terms, this represents $1M/(1.10) = 0.909M, since
the one year inflation rate is 10%. If these earnings continue to grow at the rate of inflation, then
they will be constant in real terms, so we discount the level perpetuity of 0.909M at the real
interest rate of 9.09% (Note that (1 + nominal rate) = (1 + real rate)(1 + expected inflation). The
NPV is $10M (=0.909M/0.0909).
3. In late 1985, Donald Trump, the New York real estate developer, unveiled a plan to build the
tallest building in the world on Manhattan’s West Side as the centerpiece of a commercial
and residential complex to be known as Television City. He bought the land in 1981 for only
$81 million. By 1985, its estimated value was $2 billion. “I can do things that no one else
can do because I got the land so cheap,” said Trump. The Donald is (was?) very rich, but is
he correct?
Answer: Perhaps Donald Trump presents a different face to the public. If he uses $81M as the
cost of the property, any investment will look profitable, even the simple strategy of selling the
undeveloped property for $2B. Other development strategies have to compete against this simple
strategy; they will not look as profitable in this light. In other words, the present value of the
marginal benefits of any development project he undertakes should exceed the present value of the
marginal costs of the development. The calculation of marginal benefits will not include the
tremendous increase in the value of the land.
Consider the following example. Suppose the present value of the benefits of a proposed real-
estate project is $100M. How should Trump determine its NPV?
A. $100M ─ $81M = $19 Million
B. $100M ─ $ 2B = ─$1.9 Billion
Method A is consistent with Trump’s statement. Method B, however, is correct.
4. In May 1992, IBM announced plans to resell the ultra-powerful PCs of Parallan Computer.
However, according to one analyst, “In pushing into increasingly powerful and expensive
PCs, IBM runs the risk of cannibalizing its own sales of minicomputers.” How should this
possibility be factored into IBM’s investment decision?
Answer: Answer. The real question that IBM should raise is not whether it will lose sales of its
existing minicomputers but what will happen to sales if it doesn’t sell Parallan’s PCs. In other
words, the relevant consequence of sales of Parallan’s PCs for capital budgeting purposes is the
incremental effect of any cannibalization that occurs—which equals the lost profit on lost sales
that would not otherwise have been lost had the new product not been introduced. Those sales
that would have been lost anyway should not be counted a casualty of cannibalization.
In general, a project’s incremental cash flows can be found only by subtracting worldwide
corporate cash flows without the investment—the base case—from post-investment corporate
cash flows. To come up with a realistic base case, and thus a reasonable estimate of incremental
cash flows, the key question that managers must ask is, “What will happen if we don’t make this
investment?” The critical error made by many companies is to ignore competitor behavior and
assume that the base case is the status quo. But in a competitive world economy, the least likely
future scenario is the status quo. A company that opts not to come out with a new product
because it is afraid that the product will cannibalize its existing product line is most likely leaving
a profitable niche for some other company to exploit. Sales will be lost anyway, but now they will
be lost to a competitor. Similarly, a company that chooses not to invest in a new process
technology because it calculates that the higher quality is not worth the added cost may discover
that it is losing sales to competitors who have made the investment. In a competitive market, the
rule is simple: If you must be the victim of a cannibal, make sure the cannibal is a member of your
family.
Failure to heed this rule led IBM to slight investment in and sales of small computers despite the
challenge from personal computers, minicomputers, and workstations; small computers looked
less profitable to sell than IBM’s mainframes. Instead of trying to figure out a way to compete in a
world in which the advent of the microprocessor, and the powerful personal computers and
workstations it helped create, turned computer hardware into a low-margin commodity product,
IBM tried to protect its profitable mainframe business by slowing down or axing products that
were even vaguely competitive with its mainframes. For example, in the mid-1970s, IBM
researchers pioneered reduced instruction-set computing, or RISC, a revolutionary technology for
designing faster computers. But the advance wasn’t rushed into products, largely because it was
seen as a menace to IBM’s mainframe business. Competitors like Sun Microsystems, Dell,
Compaq, and Hewlett-Packard, with no mainframe business of their own to protect, took
advantage of IBM’s inertia by running rings around it in the personal computer and workstation
markets (Sun harnessed RISC technology to now lead in RISC-based workstations), stealing sales
from its mainframe business anyway. By trying so hard not to cannibalize its mainframes, IBM lost
sales and profits to its competitors.
In contrast to IBM, Intel is a model cannibal. Once threatened by copycats cloning its popular
80386 chip, the semiconductor giant responded aggressively. Intel slashed prices, undercutting the
cloners, then rolled out a better generation of chips that will eventually make its old lines obsolete.
According to one analyst, “Intel said to competitors: ‘You’d better run as fast as we are, because
we’re destroying the pavement behind us as we move along.’ They plundered and burned the 386
market. Trashed it. Destroyed it.” If IBM fails to sell Parallan’s PCs because of a fear of
cannibalization, it will likely just be repeating its past errors.
5. Flexible manufacturing systems enable companies to respond quickly to emerging market

trends and to easily accommodate product redesigns as technology changes. What is there in
these advantages that sometimes leads companies applying the traditional discounted cash
flow analysis to under-invest in such systems? That is, why do companies sometimes
underestimate the value of flexible manufacturing systems in the sense of assigning negative
NPVs to positive NPV projects?
Answer: Flexible manufacturing systems are often costly, difficult to administer, and hard to
defend in the short term. However, they make it easier for a company to adapt to a changing
technological and business environment and a more competitive marketplace. That is, they give
companies options that would otherwise might not exist. With such systems in place, the firm will
find it easier to enter and capture niche markets as they emerge. The relevant base case may not
be the status quo, but rather, an anticipated decline in sales following competitors’ adaptations to
the new technology. This ease of adaptation has a value to the firm; it may make all future
investments more profitable. Firms may underestimate NPV when they fail to take the option-like
characteristics of the new technology into account, and mistakenly assume that the status quo will
be maintained in the absence of adaptation.
6. Many companies are now installing marketing and sales productivity (MSP) systems that
automate routine tasks and gather, update, and interpret data that were either scattered or
uncollected before. These data include information about every sales lead generated, every
sales task performed, and every customer prospect closed or terminated. Describe some of
the direct costs and benefits that might be associated with an MSP system. What are some
intangible benefits of an MSP system as well as some hidden costs of implementing such a
system?
Answer: An MSP system delivers tangible productivity gains, like reducing paper work,
improving the quality of telephone campaigns by pre-qualifying sales leads, and increasing sales
force productivity by reducing the time salepeople spend on non-selling tasks (such as scheduling
sales calls, compiling sales reports, generating proposals and bids, and entering orders). Intangible
benefits are more difficult to quantify, but may be more important in the long run. An MSP system
tracks every one of a company’s marketing and sales activities, from advertising that generates
sales leads to direct mail and telephone qualification of the leads to closing the first sale—all the
way through the life of each account. By analyzing the data the MSP system gathers—data that
were previously unavailable—marketing and sales management are now able to relate marketing
actions with marketplace results. As such, an MSP system can improve the timeliness and quality
of marketing decision making and lead to more responsive customer service and deeper
understanding of customers. MSP systems also reduce marketing inertia because they streamline
the implementation of marketing programs. Moreover, by linking orders, services delivered, and
prices paid with the actual costs of lead generation, preselling, closing, distribution, and post sale
support, MSP systems furnish the tools for analyzing and adjusting the marketing mix (personal
selling, direct mail, telemarketing, advertising, pricing, other promotional efforts) and product
mix.
The direct costs of such a system include the cost of the computer and telecommunications
hardware, the software, and the cost of tying all those pieces together. Expensive as these direct
costs are, the hidden costs can double or even triple the overall cost. These hidden costs include
system customization, expert consulting, and end-user training. Moreover, because
malfunctioning of an automated marketing system can threaten a business’s revenue stream, most
companies will probably have to run both systems—automated and manual—until the network
has proved out .
7. Accrued pension benefits represent an obligation of a company for the past service of its
employees. No current or future action can affect this obligation. The amortization of
accrued pension benefits must be recognized, however, as a current expense in the company’s
financial statements. Many companies turn around and allocate these costs to divisions. One
company allocated these costs in proportion to pension benefits accrued by its workers. A
plant with an older work force received almost all of its division’s accrued pension costs,
adding $4 per hour to the plant’s labor cost relative to the cost of several newer plants with
much younger workers.
a. How is this allocation of accrued pension benefits likely to affect future investment
decisions? The competitiveness of products manufactured by the plant?
Answer: Some positive NPV future investment decisions may be foregone if the divisions assign
accrued pension benefits to the projects considered. Pension obligations committed in the past
represent sunk costs. Also, the division in a competitive environment will be expected to show
strong profits net of accrued pension benefits. In a competitive market, the firm may not be able
to cut price enough to retain market share if it is required to price high enough to cover its
accrued pension liabilities.
b. Suppose that because of its high labor costs, the company decided to shut down the older
plant and shift work to the newer ones. How will this decision affect the company’s
competitiveness?
Answer: The company must still meet its accrued pension obligation. It is possible that the shut-
down will improve the company’s competitiveness, but the merits of this decision should be
evaluated in the absence of lower apparent accrued pension costs. It is more likely that the
company would become less competitive; older workers may be more skilled and/or more
productive than their younger counterparts.
c. How should the company treat accrued pension benefits for investment, product sourcing,
and pricing purposes?
Answer: The company should treat existing pension benefits as (sunk) overhead. For pricing
purposes, it should examine only the marginal addition to pension liability that a project will
cause, and allocate only this cost to the project.
8. Starshine Products is considering the launch of a new line of dolls that would use an
assembly line that currently has some spare capacity. Some Starshine executives argued that
because the assembly line was already paid for, its cost was sunk and should not be included
in the project evaluation. Others argued that the assembly line was a scarce resource and
should be priced accordingly. What cost should Starshine assign to use of the excess
assembly line capacity?
Answer: The cost associated with the additional use of the line due to the new project should be
allocated to the new project. This includes, but is not limited to, the additional costs of power,
labor, maintenance and repair, changes in expected replacement costs incurred earlier by
additional use, and any opportunity costs of the line usage. For example, are there other potential
future uses of the spare capacity, e.g. sales growth of the current product line? The answer
depends upon the alternative uses of the assembly line.
9. In order to produce its new line of canned foods, Hammond Foods must purchase a
specialized piece of equipment that has the capacity to fill a million cans annually. Suppose
Hammond plans to initially produce 150,000 cans annually. Some executives argued that the
new product line should be charged for only 15 percent of the cost of the new equipment.
Others argued that it should bear the full cost of the special-purpose machinery. Who is
right? Explain.
Answer: It would be appropriate to charge the full cost of equipment against the project’s
benefits provided there is no other user. Clearly, the machine (the remaining 85%) would not be
purchased in the absence of this production decision; it represents a truly incremental cash flow.
Also, to the extent that the extra capacity gives the company an option to cheaply expand
production, the option value should also be included in the purchase/production decision.
10. Happy Tub makes traditional cast- iron bathtubs. However, the company was thinking of
adopting a novel proprietary casting process to make lighter bathtubs that could compete
better against plastic ones which were eating into sales, while also reducing raw materials
costs. The $25 million investment seemed wise from a marketing perspective, but its NPV
came to - $3 million. What other factors should you consider in light of the following
assumptions that entered into this figure?
a.The base case implicitly assumed that sales would stay the same without the new
investment.
b.Happy Tub has two plants, both running below capacity. Since just one plant would be
upgraded, however, only products made at that plant would benefit from the new efficiencies.
Thus, the finance director used a high discount rate to reflect the highly uncertain volumes
and costs savings from using the new process.
c. Happy Tub used a standard ten- year life to evaluate the new project. Since ten years was
also the standard life over which plant and machinery were depreciated, the finance director
inserted a zero terminal value for the upgraded plant.
d.Happy Tub ignored the other opportunities that the introduction of the proprietary casting
process might create since these opportunities were purely speculative.
e. Although the proprietary casting process promised quality improvements, the investment
analysis assumed that any sales of the new bathtub would just replace sales of Happy Tub’s
cast iron tubs. The analysis considered the cost savings from reduced raw materials usage to
be the only source of project gains.
Answer:
CHAPTER 3: PROBLEMS
1. TelCo must decide whether to replace a computer system with a new model. TelCo forecasts
net before- tax cost savings from the new computer over five years as given below (in $000).
It has a 12 percent cost of capital, a 35 percent tax rate, and uses straight- line depreciation.
Year 1 2 3 4 5
($) 350 350 300 300 300
a. The new computer costs $1 million but TelCo is eligible for a 15 percent investment tax
credit (ITC) in the first year. The ITC reduces Telco’s taxes by an amount equal to 15 percent
of the equipment’s purchase price. In addition, the old computer can be sold for $450,000. If
the old computer originally cost $1.25 million and is three years old (depreciable, not
economic, life is five years), what is the net investment required in the new system? Assume
that there was no ITC on the old computer and that both computers are being depreciated to
a zero salvage value.
Answer: All figures are in thousands. The net investment in the machine can be found by the
following equation:
Net Inv = Cost - Salv(Old) + Tax from sale of Old = 1000 - 450 - 0.35(50) = $532.50.
The book value of the old machine was $500, but it can be sold for $450, at a $50 loss. The
writeoff is worth 0.35(50) = $17.50 to the company. This reduces the effective investment in the
new machine.
b. Estimate the incremental operating cash flows associated with the new system.
Answer: The incremental cash flows can be found by calculating:
Incr Cash Flow = After Tax Savings + t * (Net Depreciation)
c. If the new computer’s salvage value at the end of five years is projected to be $100,000,
should TelCo purchase it?
Answer: If the computer has a salvage value after 5 years, and is sold at that time, the book
value will be zero, and the company will have to pay a tax of 0.35 * 100 = $35 at that time. This
changes the marginal cash flow to 265 + 100 - 35 = $330 in year 5.
The present value of the marginal cash flows (at 12%) is $899.19. The net present value is
899.19 - 532.50 = $366.70. The new computer should be purchased.
2. New diesel locomotives will cost a railroad $600,000 each and can be depreciated straight-
line over their five-year life. Using a diesel instead of a coal-fired steam locomotive will save
$12,000 annually in operating expenses. Railroads have a required rate of return of 10
percent and a tax rate of 40 percent.
a. What is the maximum price a railroad would be willing to pay for a coal-fired steam
locomotive? (Hint: Set up the cash flows for a coal-fired locomotive at a price of P, including
depreciation, and then compare them to the incremental cash flows associated with a diesel
costing $600,000.)
Answer: PVIFAr=10%,n=5 = 3.790787.

Consider the decision to switch from coal-fired steam locomotives to diesel locomotives. We will
find the indifference point by assuming that the net present value of the switching decision is zero.
All figures are reported in thousands. The incremental cost is (600 ─ P). Annual incremental
cash flows = (1─t)(Savings) + t(Incr Depr). = 0.6(12) + 0.4(120 ─ 0.2P) = 55.2 ─ 0.08P. The
present value of the incremental cash flows is PVIFA´(55.2 ─ 0.08P) or 209.251442 ─
0.303263P. Setting this expression equal to 600 ─ P, we solve for P = $560.826. This makes
NPV = 0.
b. Will your answer to (a) change if the railroad has enormous tax-loss carryforwards that
put it in a zero taxpaying position for the foreseeable future?
Answer: Enormous tax loss carryforwards make the effective tax rate equal to zero. Therefore,
the annual incremental cash flow is $12, and its present value is 12 ´ 3.790787 = 45.4894. Setting
this equal to the marginal cost of (600 ─ P), we get P = $554,511. The value of the cost savings
obtained by the purchase of diesel locomotives is higher, since the savings are not taxed. This
makes the diesel relatively more valuable in this instance.
3. Varico produces HO- scale trains, including a diesel locomotive that sells 100,000 units
annually. Each unit requires an electric motor. Presently these are purchased once a week
from a local manufacturer for $10 apiece. However, a foreign firm has offered to sell Varico
a container of 100,000 motors of like quality for only $9.50 apiece. Given an interest rate of
15 percent, what should Varico do?
Answer: By buying 100,000 motors today, the firm will have average inventory on hand of
50,000 during the year. The opportunity cost of maintaining this inventory equals
Average
Number of Price Per Interest Rate
x x
Units on Unit
Hand
= 50,000 x $9.50 x 0.15 = $1,250
By buying weekly, the firm incurs no interest expense. Thus, the real cost of buying 100,000
motors today is $950,000 + $71,250 = $1,021,250. This exceeds the $1M that it costs to buy
motors at $10 apiece on a weekly basis.
4. To capitalize on consumers’ concerns about healthful food, Specific Foods, Inc., is

considering a new cereal, Veggie Crisp, which contains small bits of cooked vegetables with
bran flakes. As part of its cash flow analysis, the finance department has made the following
forecasts of demand and cost:
a. Sales revenue for the first year will be $200,000 and increase to $1,000,000 the next
year. Revenue will then grow by 15 percent a year for the next four years, remain the
same in the seventh year, and then decline by 15 percent a year for the next three years,
when the product will be terminated.
b. Cost of goods sold will be 60 percent of sales.
c. Advertising and general expenses will be $10,000 a year.
d. Equipment will be purchased today for $1,250,000 and will be depreciated over the ten-
year project using the straight-line method. Installation cost today is $25,000, and this is
depreciated over five years, also on a straight-line basis. The equipment has no salvage
value. Other initial costs (which are expensed, not depreciated) total $875,000. There is
no investment tax credit.
(i). Calculate net income and operating cash flow using a 35 percent tax rate.
Answer: The income and cash flow statement ($000’s) appears below (rounded mercilessly: Total
PV is accurate to decimal places shown)
Year 1 2 3 4 5 6 7 8 9 10
Sales 200 1000 1150 1323 1521 1749 1749 1487 1264 1074
CGS 120 600 690 794 913 1049 1049 892 758 644
Adv/Gen 10 10 10 10 10 10 10 10 10 10
Depr (Equip) 125 125 125 125 125 125 125 125 125 125
Depr(Inst) 5 5 5 5 5 0 0 0 0 0
OCF 91 299 338 383 434 492 492 424 366 317
PV(r=10%) 83 247 254 261 270 278 252 198 155 122
Tax rate = 35% Total PV = $2120.065
b. Find the net present value of the project using a 10 percent cost of capital.
Answer: Cost today = 1250 + 25 + 875(1 ─ 0.35) = $1843.750.

NPV($000’s) = 2120.065 ─ 1843.750 = $276.315.
The project should be accepted.
c. In an effort to adjust for inflation, the finance department has produced an alternative
estimate of cash flows. The product price will remain the same, but advertising and general
expenses will grow by 5 percent a year from its initial level of $10,000. In addition, the cost
of goods sold will grow by 20 percent a year from its initial level of $600,000 until year 6,
remain the same in year 7, and then decline by 15 percent a year through year 10. What is
the project’s net present value under these assumptions?
Answer: Under the new cash flow estimates, the project should be rejected:
Year 1 2 3 4 5 6 7 8 9 10
Sales 200 1000 1150 1323 1521 1749 1749 1487 1264 1074
CGS 120 600 720 864 1037 1244 1244 1058 899 764
Depr(Equip) 10 11 11 12 12 13 13 14 15 16
Depr(Inst)
OCF
PV(r=10%)
┌─────────┬─────────────────────────────────────────────┐
│Year │1 2 3 4 5 6 7 8 9 10 │
│Sales │200 1000 1150 1323 1521 1749 1749 1487 1264 1074 │
│CGS │120 600 720 864 10371244 1244 1058 899 764 │
│Adv/Gen │ 10 11 11 12 12 13 13 14 15 16 │
│Depr(Equip) │ 125 125 125 125 125 125 125 125
125 125 │
│Depr(Inst) │ 5 5 5 5 5 0 0 0 0 0 │
│OCF │ 91 299 318 336 352 364 363 314
271 235 │
│PV(r=10%) │ 83 247 239 229 219 205 186 146 115
91 │
└─────────┴───────────────────────────────────┘
Tax rate = 35% Total PV = $1760.160
NPV($000’s) = 1760.160 ─ 1843.750 = ─$83.590.
5. In building a new facility for producing trucks, International Truck (IT) must estimate the
total investment required. In the current year, IT estimates it will acquire land for the plant at
$1,000,000 and modify existing plant equipment for $123,000. Next year, construction will begin
and require $866,000, and further plant modifications will require $344,000. In addition, new
equipment worth $140,000 will be purchased (with a 10 percent investment tax credit). The new
equipment will require $250,000 of installation expense. Finally, in the next year, construction will
be completed at a cost of $750,000; installation charges will total $229,000; and building
modifications will require $350,000. Lastly, more new equipment will be purchased for $230,000
(with a 10 percent ITC). With a cost of capital of 10 percent, what is the present value of the initial
investment required for the plant?
Answer:
Year 0 1 2
Land 1,000,000
Modification 123,000
Construction 866,000 750,000
Modification 344,000 350,000
New Equipment 126,000* 207,000*
Installation 250,000 229,000
Totals 1,123,000 1,586,000 1,536,000
PV (10%) 1,123,000 1,441,818 1,269,421
Total PV $3,834,239
*Net of investment tax credit
6. Yankee Atomic Electric Co. announced in 1992 that it would decommission its Yankee
Rowe nuclear plant at an estimated cost of $247 million. The cost includes:
i. $32 million to maintain the plant until 2000, when dismantling will begin. These expenses
will accrue at the rate of $4 million a year.
ii. $56.5 million for the cost of building a facility to store its spent fuel until it is shipped in
2000 to a permanent repository. This storage facility will be depreciated straight-line over its
eight-year estimated life.
iii. $158.5 million for the cost of dismantling the plant in 2000 and disposing of its nuclear
wastes.
At the same time, Yankee Atomic estimated that decommissioning the plant in 1992, eight years
earlier than its planned retirement in 2000, will save it $116 million ($14.5 million a year) before
tax by enabling the utility to purchase cheaper electricity than Yankee Rowe could provide. In
addition, Yankee Atomic said it had accumulated $72 million in a decommissioning fund required
by the Nuclear Regulatory Commission.
a. What is the present value of Yankee’s $247 million decommissioning cost. Assume a cost of
capital equal to 12 percent and a 34 percent tax rate.
Answer: . In order to answer this question we must make some assumptions regarding the timing
of the various cash flows. Assume that the maintenance and storage facility costs begin
immediately in 1992. The costs associated with the storage facility include an initial outlay of
$56.5 million and subsequent depreciation tax shields worth $2,471,875 annually (0.35 ?
$56,500,000/8) beginning in 1993 and continuing through 2000. All cash flows are assumed to
occur at the beginning of the year, that is, the 1992 cash flows are expected to occur immediately
and so on. As shown in the bottom row of this table, the present value of these net costs
discounted at 12% is $160 million.
Year Maintenance Storage Facility Dismantling/Disposal Costs Total Cash Flows
1992 56,500,000 56,500,000
1993 4,000,000 (2,471,875) 1,528,125
1994 4,000,000 (2,471,875) 1,528,125
1995 4,000,000 (2,471,875) 1,528,125
1996 4,000,000 (2,471,875) 1,528,125
1997 4,000,000 (2,471,875) 1,528,125
1998 4,000,000 (2,471,875) 1,528,125
1999 4,000,000 (2,471,875) 1,528,125
2000 4,000,000 (2,471,875) 158,500,000 160,028,125
Present value @ 12% $128,106,666
b. Taking into account the savings on the purchase of cheaper electricity, and the $72 million
already set aside, how much additional money does Yankee Atomic have to set aside in 1992 to
have enough money to pay for the decommissioning expense?
Answer: The following table takes into account the savings on the purchase of cheaper electricity.
Not that the annual after-tax fuel savings of $9,245,000 ($14.5 million net of tax at 35%, or
$14,500,000 ? 0.65) show up with a negative sign because it is a cost reduction. The net present
value of these costs as shown on the bottom line is $81.3 million. Yankee Atomic has to set aside
an additional $9.3 million in 1992 to make up the shortfall ($81.3 million - $72 million).
Year Maintenance Storage Facility Dismantling/Disposal Costs After-tax Fuel Savings
Total Cash Flows
1992 56,500,000 56,500,000
1993 4,000,000 (2,471,875) (9,425,000) (7,896,875)
1994 4,000,000 (2,471,875) (9,425,000) (7,896,875)
1995 4,000,000 (2,471,875) (9,425,000) (7,896,875)
1996 4,000,000 (2,471,875) (9,425,000) (7,896,875)
1997 4,000,000 (2,471,875) (9,425,000) (7,896,875)
1998 4,000,000 (2,471,875) (9,425,000) (7,896,875)
1999 4,000,000 (2,471,875) (9,425,000) (7,896,875)
2000 4,000,000 (2,471,875) 158,500,000 (9,425,000) 150,603,125
Present value @ 12% $81,286,661
c. What other factors might you consider in calculating the cost of decommissioniong?
Answer: Given the ever-stiffening environmental laws, it would make sense to take into account
the likelihood that cleanup standards–and hence costs–will rise over time. At the same time, it
would make sense to try to lock politicians into the decommissioning program so that it would be
grandfathered in the event of tougher laws.
7. Oldham Industries is considering replacing a 5-year old machine with an original life of 10
years, a cost of $100,000, and a zero salvage value, with a new and more efficient machine.
The new machine will cost $200,000 installed and will have a 10-year life. The new machine will
increase sales by $25,000 and decrease scrap cost by $10,000 per year. The old machine can
be sold currently at $50,000, and Oldham’s marginal tax rate is 50 percent. Assume straight-line
depreciation and a 10 percent investment tax credit for both the old and the new machines. A
prorated portion of any investment tax credit must be returned to the IRS for equipment sold
before the end of its depreciable life; that is, if half the equipment’s life remains, then half the
ITC is reclaimed by the IRS. Assume depreciation is taken on 100 percent of the cost of
equipment.
a. What is the initial cash outflow generated by the machine replacement?
Answer:
b. What are the annual operating cash flows generated by this project?
Answer:
c. What is the net present value of this replacement project, given a 12 percent cost of
capital?
Answer:
8. Molecugen has developed a new kind of cardiac diagnostic unit. Owing to the highly
competitive nature of the market, the sales department forecasts demand of 5,000 units in the
first year and a decrease in demand of 10 percent a year after that. After five years, the project
will be discontinued with no salvage value. The marketing department forecasts a sales price of
$15 a unit. Production estimates operating cost of $5 a unit, and the finance department
estimates general and administrative expenses of $15,000 a year. The initial investment in land
is $10,000, and other nondepreciable setup costs are $10,000.
a. Is the new project acceptable at a cost of capital of 10 percent? (Note: Use straight-line
depreciation over the life of the project and a tax rate of 35 percent.)
Answer: Demand Growth ─10% Price Growth 0%
┌─────────┬────────────────────────────────────┐
│Year │ 1 2 3 4 5 │
│Demand │ 5000 4500 4050 3645 3281 │
│Sales Price │ 15.00 15.00 15.00 15.00 15.00 │
│Revenue │ 75,000 67,500 60,750 54,675 49,208 │
│Costs │ 25,000 22,500 20,250 18,225 16,403 │
│Expenses │ 15,000 15,000 15,000 15,000 15,000 │
│NOI │ 22,750 19,500 16,575 13,943 11,573 │
└─────────┴────────────────────────────────────┘
Total PV = 65,960 NPV = 45,960 (Acceptable)
b. If the marketing department had forecast a decline of 15 percent a year in demand, would
the project be acceptable?
Answer: Demand Growth ─15%
┌─────────┬────────────────────────────────────┐
│Year │ 1 2 3 4 5 │
│Demand │ 5000 4250 3613 3071 2610 │
│Revenue │ 75,000 63,750 54,188 46,059 39,150 │
│Costs │ 25,000 21,250 18,063 15,353 13,050 │
│NOI │ 22,750 17,875 13,731 10,209 7,215 │
└─────────┴────────────────────────────────────┘
c. If the marketing department had forecast a decline in sales price of 10 percent a year,
along with the 15 percent annual decline in demand predicted in (b), would the project be
acceptable?
Answer: . Demand Growth ─15% Price Growth ─10%
┌─────────┬──────────────────────────────┐
│Year │ 1 2 3 4 5 │
│Demand │ 5000 4250 3613 3071 2610 │
│Sales Price │ 15.00 13.50 12.15 10.94 9.84 │
│Revenue │ 75,000 57,375 43,892 33,577 25,687│
│Costs │ 25,000 21,250 18,063 15,353 13,050│
│Expenses │ 15,000 15,000 15,000 15,000 15,000│
│NOI │ 22,750 13,731 7,039 2,096 ─1,536│
└─────────┴───────────────────────────── ┘
d. If prices decline by 10 percent a year, the marketing department estimates that demand
will be a constant 5,000 units a year. Is the project acceptable?
Answer:
Demand Growth 0% Price Growth ─10%
┌─────────┬───────────────────────────────────┐
│Year │ 1 2 3 4 5 │
│Demand │ 5000 5000 5000 5000 5000 │
│Sales Price │ 15.00 13.50 12.15 10.94 9.84 │
│Revenue │ 75,000 67,500 60,750 54,675 49,208 │
│Costs │ 25,000 25,000 25,000 25,000 25,000 │
│Expenses │ 15,000 15,000 15,000 15,000 15,000 │
│NOI │ 22,750 17,875 13,488 9,539 5,985 │
└─────────┴──────────────────────────────────── ┘
9. Salterell Textiles is considering replacing the looming equipment in its North Carolina mill.
The original purchase price was $79,300 two years ago. The machine has a useful life of ten
years and is being depreciated using the straight-line method. The old equipment can be sold
today for $10,800. The new equipment costs $80,500 and has an eight-year life. Its salvage
value is expected to be $8,000. The new equipment is expected to increase output and sales
revenue by $9,000 a year (after tax) and reduce costs by $7,500 (after tax).
a. With a tax rate of 25 percent and a 14 percent cost of capital, what should Salterell’s
decision be?
Answer: NPV = PV(Revenue & Savings) + NPV(New Machine) + NPV(Old)
NPV(Revenue & Savings) = (9000 + 7500) ´ PVIFr=14%,n=8
= 16,500 ´ 4.6389 = $76,541.25. (after tax)
NPV(New Machine) = ─Cost + PV(Depr) + PV(After tax salvage)
= ─80,500 + 0.25 ´ 10,062.50 ´ 4.6389 + 8000(0.75)(0.3506 = PVIF)
= ─$66,726.67.
NPV(Old Machine) = [After Tax Sales Proceeds] ─ PV(Depr)
= [10,800 ─ 0.25(10,800 ─ 63,440*)] ─ 7930 ´ 0.25 ´ 4.6389
= $14,763.45.
Overall NPV = $76,541.25 ─ 62,830.27 + 14,763.45 = $24,578.
b. Would a 10 percent ITC change the analysis?
Answer: A 10% Investment Tax Credit would reduce current taxes by 0.10(80,500) = $8050. The
effective NPV of the New Machine is increased to ─58,676.67, and the overall NPV is increased
to $32,628.
c. If an inflation rate of 7 percent a year must be incorporated into the decision, is the project
acceptable?
Answer: An inflation rate of 7% will increase nominal revenues, costs and salvage values, but will
not affect depreciation or after-tax value of the sale of an existing asset (assuming the 7% inflation
rate was already included in the nominal discount rate). As such, the inclusion of inflation will only
make the net present value picture rosier.
10. Ross Designs is thinking of replacing its seven-year-old knitting machine with a new one
that can also emboss designs on cloth. This will allow Ross to sell its textiles, which currently
wholesale for $1.20 a yard, for $0.07 a yard more. The embossing should also raise sales 15
percent, to 2.07 million yards annually. The new machine costs $320,000, has annual operating
costs of $27,000, and is expected to last for eight years. Labor, materials, and other expenses
are estimated to rise by $0.02, to $1.10 per yard. Working capital requirements should remain
at 30 percent of sales. All working capital investments will be recaptured in eight years. The
current machine was purchased for $190,000 and is being depreciated on a straight-line basis
assuming a 10-year life. Its economic life as of today, however, is estimated to be eight years,
the same as that of the new machine. It can be sold for $70,000 today, or for an estimated
salvage value of $5,000 in eight years. The new machine will be depreciated straight line over a
five-year period, and has an estimated salvage value of $20,000 in eight years. The appropriate
discount rate is estimated at 12 percent.
a. What is the change in operating cash flows for each year? What is their present value?
Answer: Here are the incremental cash flows associated with the new machine. The present value
of these cash flows, discounted at 12%, is $416,409. Although it is not mentioned in the problem,
the tax rate is assumed to be 35%. Note that the incremental depreciation varies from year to year,
depending on the old and new depreciation schedules.
Year 1 2 3 4 5 6 7 8
2,628,900 2,628,900 2,628,900 2,628,900 2,628,900
2,628,900 2,628,900 2,628,900
Old sales revenue 2,160,000 2,160,000 2,160,000 2,160,000
2,160,000 2,160,000 2,160,000 2,160,000
Incremental sales revenue 468,900 468,900 468,900 468,900
468,900 468,900 468,900 468,900
Annual machine operating costs 27,000 27,000 27,000 27,000
27,000 27,000 27,000 27,000
Other costs (new) 2,277,000 2,277,000 2,277,000
2,277,000 2,277,000 2,277,000 2,277,000 2,277,000
Other costs (old) 1,944,000 1,944,000 1,944,000
1,944,000 1,944,000 1,944,000 1,944,000 1,944,000
Incremental other costs 333,000 333,000 333,000
333,000 333,000 333,000 333,000 333,000
Depreciation (new) 64,000 64,000 64,000 64,000
64,000
Depreciation (old) 19,000 19,000 19,000
Incremental depreciation 45,000 45,000 45,000 64,000
64,000
Incremental before-tax profit 63,900 63,900 63,900
44,900 44,900 108,900 108,900 108,900
Incremental tax @ 35% 22,365 22,365 22,365 15,715
15,715 38,115 38,115 38,115
Incremental after-tax profit 41,535 41,535 41,535 29,185
29,185 70,785 70,785 70,785
Incremental depreciation 45,000 45,000 45,000 64,000
64,000
Incremental operating cash flow 86,535 86,535 86,535 93,185 93,185
70,785 70,785 70,785
Present value @12% 77,263 68,985 61,594 59,221
52,876 35,862 32,020 28,589
Cumulative present value $77,263 $146,249 $207,842 $267,063
$319,939 $355,801 $387,820 $416,409
b. What are the net cash flows associated with the purchase of the new knitting machine and
sale of the old one?
Answer: If Ross purchases the new machine, it will have an initial outlay of$320,000 and cash
receipts of $70,000 from the sale of the old machine. After seven years of straight-line
depreciation, the old machine will have a book value of $57,000. Hence, Ross will have to pay tax
of $4,550 on the recapture of $13,000 in excess depreciation ($13,000 x 0.35). Thus, Ross’s net
cash outlay will be $254,550 ($320,000 - 70,000 + 4,550). At the end of eight years, Ross will sell
its new machine for an estimated $20,000. However, since the book value will be 0, Ross will
have to pay tax of $7,000 ($20,000 x 0.35) on the recaptured depreciation. This leaves Ross with
a net cash inflow of $13,000 in eight years. There is one more impact of the purchase of the new
machine: Ross loses the estimated $5,000 salvage value of the old machine at the end of year 8.
At the same time, Ross avoids paying tax of $1,750 on the recaptured depreciation, leaving it
with a net loss of $3,250. Hence, the net effect of the purchase of the new machine and sale of
the old one on year 8 cash flows is a net increase in cash flow for that year of $9,750 ($13,000 -
$3,250). The purchase of the new machine also affects intermediate-term cash flows through its
effects on depreciation. However, these effects have already been incorporated into the operating
cash flow analysis. The present value of Ross’s investment in the new machine is $250,612
($254,550 - $9,750/1.128)
c. What is the NPV of the investment in working capital?
Answer: The incremental working capital requirement is 30% of incremental sales, or $140,670
($468,900 x 0.30). Ross will recapture this investment at the end of year 8. Hence, the net present
value of its incremental working capital investment is $83,856 ($140,670 - $140,670/1.128).
d. What is the NPV of the acquisition of the new knitting machine? Should Ross buy it?
Answer: Combining the answers to parts (a)-(c) yields an NPV for the new knitting machine of
$81,941 ($416,409 - $250,612 - $83,856).
e. Suppose that all prices and costs are in nominal terms and will increase at the rate of
inflation, which is projected at 4 percent. How does the analysis in parts (a) through (d) change? The
12 percent discount rate is expressed in nominal terms as well.
Answer: Assuming growth in costs and sales of 4% annually yields a new present value of operating
profits equal to $460,514, as shown below, an increase of $44,105 compared its value before.
Year 1 2 3 4 5 6 7 8
New sales revenue 2,628,900 2,734,056 2,843,418 2,957,155
3,075,441 3,198,459 3,326,397 3,459,453
Old sales revenue 2,160,000 2,246,400 2,336,256 2,429,706 2,526,894
2,627,970 2,733,089 2,842,413
Incremental sales revenue 468,900 487,656 507,162 527,449 548,547
570,489 593,308 617,040
Annual machine operating costs 27,000 28,080 29,203 30,371 31,586 32,850
34,164 35,530
Other costs (new) 2,277,000 2,368,080 2,462,803 2,561,315
2,663,768 2,770,319 2,881,131 2,996,377
Other costs (old) 1,944,000 2,021,760 2,102,630 2,186,736 2,274,205
2,365,173 2,459,780 2,558,171
Incremental other costs 333,000 346,320 360,173 374,580 389,563
405,145 421,351 438,205
Depreciation (new) 64,000 64,000 64,000 64,000 64,000
Depreciation (old) 19,000 19,000 19,000

Incremental depreciation 45,000 45,000 45,000 64,000 64,000
Incremental before-tax profit 63,900 68,256 72,786 58,498 63,398
132,494 137,793 143,305
Incremental tax @ 35% 22,365 23,890 25,475 20,474 22,189
46,373 48,228 50,157
Incremental after-tax profit 41,535 44,366 47,311 38,023 41,208
86,121 89,566 93,148
Incremental depreciation 45,000 45,000 45,000 64,000 64,000
Incremental operating cash flow86,535 89,366 92,311 102,023 105,208
86,121 89,566 93,148
Present value @12% 77,263 71,242 65,705 64,838 59,698
43,631 40,515 37,621
Cumulative present value $77,263 $148,506 $214,211 $279,049
$338,747 $382,378 $422,893 $460,514
At the same time, working capital requirements rise year by year at the rate of 4% annually. The
present value of these increases net of their return at the end of year 8 is $94,374, as shown below.
This figure is $10,518 more than its value of $83,856 under the no-inflation scenario.
Year 0 1 2 3 4 5 6 7 8
Incremental working capital req 140,670 5,627 5,852 6,086 6,329 6,583 6,846
7,120 (185,112)
Present value @12% $140,670 $5,024 $4,665 $4,332 $4,022 $3,735 $3,468 $3,221
-$74,764
Cumulative present value $140,670 $145,694 $150,359 $154,691 $158,713 $162,448
$165,917 $169,137 $94,374
The net effect of these changes is to increase the project NPV by $33,587 ($44,105 - $10,518).
Chapter 4: Real Options and Project Analysis
1. Imagine that the price of copper rises to the point that the copper value of a penny is worth
more than $.01. As a result, pennies disappear from circulation. Your firm uses copper in its
production process, and you can melt pennies down and retrieve their copper content at zero
cost. At present, you have a six-month supply of copper reserves and you have also managed
to collect 1 million pennies. Should you melt the pennies down and add the copper to your
stockpile? Why or why not?
Answer: The ownership of a penny is an option. If the penny is melted, the owner gets the
valuable copper to sell at current market prices. However, if the owner keeps the penny, he
retains the option to use it as legal tender. If the price of copper makes the penny’s copper
content worth less than $.01, it is more valuable as legal tender. If the penny was melted and
prices dropped, the owner may not mint a new penny. The penny is generally more valuable
as an option. Hence, it should not be melted. (It is also illegal to deface or alter legal tender.)
2. Will a gold mine ever be shut permanently? Why or why not?
Answer: A gold mine is an option to mine the gold if the market prices make it profitable to do
so. Closing a mine permanently kills the value of the option to re-open the mine if market
conditions change favorably. The only time that a mine would be closed forever is when the
cost of maintaining the mine (including opportunity costs) is higher than the marginal option
value. If the value of the option truly drops to zero, it will be optimal to close the mine.
3. Some economists have stated that too many companies aren’t calculating the cost of not
investing in new technology, world-class manufacturing facilities, or market position overseas.
What are some of these costs? How do these costs relate to the notion of growth options
discussed in the chapter?
Answer: Executives in this situation need to consider the option values associated with new
technological investment. New technologies, while often costly, difficult to administer and hard to
defend in the short term, make it easier for a company to adapt to a changing technological
environment and a more competitive marketplace. With technology in place, the firm will find it
easier to enter and capture niche markets as they emerge. The relevant base case may not be the
status quo, but rather, an anticipated decline in sales following competitors’ adaptations to the new
technology.
This ease of adaptation has a value to the firm; it may make all future investments more profitable.
Firms may underestimate NPV when they fail to take the option-like characteristics of the new
technology into account, and mistakenly assume that the status quo will be maintained in the absence
of adaptation.
4. In December 1989, General Electric spent $150 million to buy a controlling interest in
Tungsram, the Hungarian state-owned light bulb maker. Even in its best year, Tungsram earned less
than a 4% return on equity (based on the price GE paid). What might account for GE’s decision to
spend so much money to acquire such a dilapidated, inefficient manufacturer?
Answer: Eastern Europe has the potential to be both a large market for Western goods and a
low-cost manufacturing platform for export to Western Europe. But there are major uncertainties as
to whether Eastern Europe will ever realize its market potential. As to manufacturing there,
questions exist as to whether a workforce with 45 years experience in “they pretend to pay us and
we pretend to work” can produce at the level and quality necessary to be competitive with their
Western counterparts. By investing in Hungary, GE is buying an option to participate in the growth
of the Eastern European market. It also is learning what it takes to install modern Western
management methods in a former communist country and to use Hungary as a low-cost backdoor to
Western Europe. The latter is especially critical to GE as part of its strategy to expand its weak
global presence.
GE’s presence is particularly dim in the European lighting market, where it is just sixth in sales, even
though historically it has dominated the U.S. market. Then came a highly successful raid on GE’s
U.S. fortress by Philips, which is the world’s largest light bulb producer. GE decided to fight back by
storming Philip’s European base. But GE was unable to acquire a controlling interest in any Western
European firm and building a new plant would have cost at least $300 million and several years.
Buying Tungsram seemed a more promising alternative, since the Hungarian firm already exported
70% of its output to the West. Thus, it offered a tempting mix of Western European market share
and low Eastern European wages. In effect, by investing in Tungsram, GE is buying options on: (a)
the Western European market; (b) introducing new technologies and higher-priced products to
Tungsram; and (c) a low-cost export platform. In response to GE’s purchase, Philips recently took
over Poland’s leading lamp producer and another Western European competitor, Siemens’ Osram
unit, has acquired an East German producer.
CHAPTER 4: PROBLEMS
1. A biotech firm must decide whether to purchase the patent to a new food additive, a low-cal
starch substitute. It is estimated that the funds required to bring the additive to the market can be
as high as $50 million or as low as $25 million. The payoff is uncertain as well: The present value
of profits could be as high as $500 million or as low as $30 million. The risk-free rate is 10
percent, and the standard deviation of rate of return on biotech products is 35 percent. The
patent’s life is estimated at one year.
a. In a worst-case scenario, how much is the patent worth?
Answer: We need to make a few assumptions to solve this problem. We assume that in one year,
the present value of profits will take values of $500M and $30M with equal probability. We further
assume that the risk-free discount rate is the appropriate capitalization rate for the firm.
In a worst-case scenario, the costs will be $50M. The firm will only adopt the project if NPV > 0, or
PV(Benefits) = $500M. The expected net present value is 0.5(500 Ä 50) + 0.5(0) = $225M. The
present value is $225M/(1.10) = $204.55M, which represents the maximum value of the patent.
b. In a best-case scenario, how much is the patent worth?
Answer: In a best-case scenario, the costs will be $25M, and the project will be adopted no matter
what. The expected NPV is 0.5(500 Ä 25) + 0.5(30 Ä 25) = $240M. The present value is $218.18.
2. The managers of a firm are asked to consider two possible new product lines for the firm.
Project 1 is quite risky and may result in a market value for the firm of $50 million in two years, or
nothing. Project 2 is much more certain in outcome and may result in a firm market value as high as
$25 million or as low as $15 million.
The face value of the company’s debt, payable in two years, is $20 million.
a. What are the possible payoffs to the bondholders under projects 1 and 2?
Answer: (Payoffs in 2 years, in millions of dollars)
PROJECT 1:
Total Payoff Debt Distribution
50 20
0 0
PROJECT 2:
Total Payoff Debt Distribution
25 20
15 15
b. What are the possible payoffs to the shareholders under projects 1 and 2?
Answer: (Payoffs in 2 years, in millions of dollars)
PROJECT 1:
Total Payoff Equity Distribution
50 30
0 0
PROJECT 2:
Total Payoff Equity Distribution
25 5
15 0
c. Which will the shareholders favor? The bondholders?

Answer: Shareholders will favor project 1, which provides an equal or higher payoff in each state.
Bondholders favor project 2 for the same reason.
3. Eastern Shallow, Ltd., is a gold mining company operating a single mine. The present price
of gold is $300 an ounce and it costs the company $250 an ounce to produce the gold. Last year,
50,000 ounces were produced and engineers estimate that at this rate of production the mine will
be exhausted in seven years. The required rate of return on gold mines is 10 percent.
a. What is the value of the mine?
Answer: The present value of the mine is the present value of 7 years of payments of $50/oz ?
50,000 oz = $2.5M, discounted at r = 10%. This present value is $12.171M.
b. Suppose inflation is expected to increase the cost of producing gold by 10 percent a year but
the price of gold does not change because of large sales of stock-piled gold by foreign governments.
Furthermore, imagine that the inflation raises the required rate of return to 21 percent. Now, what is
the value of the mine?
Answer: If the costs rise by 10% per year while the price remains the same, we will not operate the
mine after one year. In the first year, profits are (300 Ä 275) ? 50,000 = $1.25M, discounted one
year at r = 21%. In the second year, profits are zero; we will not mine gold at $302.50 per ounce to
sell at $300 per ounce. The value of the mine is $1.25M/1.21 = $1.033M.
c. Suppose the company may shut, reopen, or abandon the mine in response to fluctuations in
the price of gold. Can the NPV method be used to value the mine under these conditions?
Answer: The NPV method can be used to determine the value of the mine if the company can
choose an optimal extraction policy. The analysis requires a potentially complex decision tree
formulation, and the determination of the optimal strategy as a function of the path of the price for
gold. The correct solution of the problem requires option-pricing methodologies.
4. G.D. Sorrell is developing an anticancer drug. The project is in its preliminary stage. G.D.S.
must decide whether to initiate a large-scale drug test costing $1.5 million a year for two years. If the
test results are positive, a $17.5 million plant to produce the drug for commercial trials will be built
at the end of the testing period. If commercial sales of the drug meet the company’s forecast for the
next two years, a second, larger plant costing $50 million will be built to produce the drug in
quantity. The cash flows resulting from this larger plant are expected to be $76 million for eight years
after it is built. The following are the relevant cash flows associated with the three possible scenarios.
Year 0 1 2 3 4 5-12
*
Scenario 1 ($1,5000) ($1,500) Unsuccessful
Scenario 2 (1,500) (1,500) (17,500) $3,000 $2,000 Unsuccessful
Scenario 3 (1,500) (1,500) (17,500) 5,000 7,500 9,500
(50,000)
a. With a cost of capital of 10 percent, value the research project using DCF analysis. Is the
project acceptable? (Assume the two plants are built.)
Answer: Assuming scenario 3 occurs, NPV = S Ci/(1.10)i = $5229.78M.
b. Assuming that the three possible scenarios have equal probability, is the project acceptable?
(Hint: Value this project as a growth option.)
Answer: In any event, $1.5M must be spent in years 0 and 1. Under scenario 1, the project is
scrapped. If the test result is successful, we may purchase an option on future cash flows for
$17.5M. At this point, either scenario has 50% chance of occurring. The PV of the cash flows as of
year 2 for scenarios 2 and 3 respectively are $4.380M and $14.637M. In either scenario, we do not
recover the $17.5M cost of obtaining the option. Therefore, the project is unacceptable in any
circumstance.
5. An oil company has paid $100,000 for the right to pump oil on a plot of land during the next
three years. A well has already been sunk and all other necessary facilities are in place. The land
has known reserves of 60,000 barrels. The company wishes to know the market value of this
operation. The interest rate is 8 percent and the marginal cost of pumping is $8 per barrel. Both
of these costs are expected to remain unchanged over the three-year period. The current price of
oil is $10 per barrel. Company economists have estimated the following:
(i) Oil will increase in price by 10 percent with a probability of 40 percent, or decrease in price
by 12 percent with a probability of 60 percent during each of the next three years.
(ii) The cost of storing oil in above-ground tanks is $.50 per year.
(iii) The company can pump a maximum of 20,000 barrels per year at the site.
(iv) The site may be shut down for a year and then reopened at a cost of $2,000.
Determine the market value of the operation ignoring taxes. Assume that all cash flows occur at the
end of each year. (Hint: Chart all possible sequences of oil prices, and calculate the optimal
production decisions and payoffs associated with each sequence.)
Answer: The possible oil price paths are diagramed below.

┌────── 13.31
┌────── 12.10 ───────┤
│ └────── 10.65
┌─ 11.00 ────┤ ┌────── 10.65
│ └────── 9.68 ───────┤
10.00 ─┤ └─────── 8.52
│ ┌────── 10.65
│ ┌────── 9.68 ───────┤
└─ 8.80 ────┤ └─────── 8.52
│ ┌─────── 8.52
└────── 7.74 ───────┤
└─────── 6.81
It is never optimal to store oil above ground; the expected price appreciation is (0.4)(0.10) +
(0.6)(─0.12) = ─3%. Furthermore, the cost is $0.50 per barrel per year. When oil prices are
high (guaranteed to be over $8.00), it is always optimal to drill. However, at the point where
prices reach $7.74, it is optimal to close. If we drill, the expected profits next year are 0.4(8.52
─ 8.00) + 0.6(6.81 ─ 8.00) = ─0.45 per barrel. Note that there would be no point in keeping
the oil; the extraction costs would be sunk. By closing, we incur a $2000 (0.10 per barrel) cost
next year, and lose $0.26 per barrel in selling last year’s production.
The results are summarized as follows:

Prob Cash Flow/Barrel PV Prob´PV
0.064 3.00,4.10,5.31 10.51 0.6725
0.096 3.00,4.10,2.65 8.40 0.8061
0.096 3.00,1.68,2.65 6.32 0.6069
0.144 3.00,1.68,0.52 4.63 0.6668
0.096 0.80,1.68,2.65 4.28 0.4113
0.144 0.80,1.68,0.52 2.59 0.3735
0.144 0.80,─.26,─.10 0.44 0.0631
0.216 0.80,─.26,─.10 0.44 ─0.0947
1.000 3.6950
The value of the project is the probability-weighted sum of the present values of the paths.
Project value = 20,000 ´ 3.6950 = $73,900.32. We ignored the value of the oil in the ground in
case of a big price drop. If that value is less than $26,099.68, it seems the oil company paid
too much for the property.
Chapter 5: Risk Analysis in Capital Budgeting
QUESTIONS
1. Comment on the following statements:
a. “Because our new expansion project has the same systematic risk as the firm as a whole,
we need do no further risk analysis on the project.”
Answer: Investors holding the firm’s stock in their portfolios will consider the systematic
risk calculation most important. However, analysis and simulation may reveal risks hidden
by the systematic risk calculation. For example, if a project might drive a firm into
bankruptcy, shareholders would have to bear deadweight bankruptcy losses and the costs
of financial distress in general.
b. “Our company should accept the new potash mine project at Moosejaw. The cost of
additional loans to fund the project is 12 percent, and our simulations lead us to expect a
14 percent return from the project.”
Answer: While the company expects a 14% return on assets, this calculation fails to
determine the required discount rate for cash flows. Furthermore, the cost of debt is not
necessarily equal to the project cost of capital. One needs to know what it would cost to
finance the project on a stand-alone basis. The 12% cost of debt financing is based on the
riskiness of the company’s assets that back the debt, not the riskiness of the project itself.
c. “It is difficult to decide whether to spend $10 million to reopen our mine because the price of
gold is so uncertain. However, if we assume the price of gold grows at an average of 5
percent a year with a standard deviation of 20 percent a year, simulation indicates the mine
has an average NPV of $500,000. Therefore, we should reopen.”
Answer: Expected net present value was calculated in the absence of a risk adjustment. For
a risk-neutral profit maximizing firm, the decision is appropriate. Since the shareholders of
most firms are not risk-neutral, a discount rate different than the risk-free rate must be used.
2. Assess the impact of the following events on a firm’s operating leverage:
a. an increase in output price due to increased demand.
b. a decrease in fixed cost.
c. negotiation of a new contract with suppliers leading to higher commitments to purchase raw
materials.
d. lowered variable labor costs per unit of output.
e. installation of new machine tools that lower variable production costs per unit of output.
Answer: In general, factors that increase the level of fixed costs within a firm also increase its
operating leverage. Therefore, event (b) reduces operating leverage while event (c) increases
operating leverage. The opposite effect prevails for variable costs. Events (a) and (d) increase the
contribution margin, and therefore reduce operating leverage. Event (e) affects both fixed and
variable costs; the dominant effect is uncertain.
3. Consider two firms, one American and the other Japanese, using identical production processes;
that is, they use the same equipment and hire the same number of workers. However, the
Japanese firm follows a no-layoff policy, whereas the American firm is willing to alter its work
force in line with changing market conditions. Which company will have the larger amount of
operating leverage? Why? How will the difference in amounts of operating leverage affect their
marketing and production decisions and strategies?
Answer: The Japanese firm will have greater operating leverage. For their firm, labor is
considered a fixed cost. Increased fixed costs increase operating leverage. The American firm
has the option to adjust the level of labor according to changes in market conditions. This option
comes at a cost. With a lower marginal cost of production, the Japanese firm will continue to
produce when the Americans lose money in production. Since their marginal cost is lower, they
will sell at a lower price and seek to aggressively capture market share; they will continue to
produce as long as marginal revenue exceeds marginal costs, regardless of their overall
profitability. The Japanese firm will emphasize sales growth since for them, with a low marginal
cost of production, revenue and profit are virtually identical.
4. The CAPM and the APT argue that only systematic risk matters; risk that is diversifiable is
irrelevant to the well-diversified investor. Yet this chapter has argued that total risk matters, not
just systematic risk. Is there an inconsistency here? Explain.
Answer: There is no inconsistency. The CAPM and APT argue that only systematic risk matters
in determining the appropriate rates to be used to discount future cash flows. They do not
demonstrate the effect of systematic and non-systematic risks on the cash flows themselves. This
chapter makes the argument that total risk may affect the level of future cash flows, and thus is
an appropriate risk consideration in capital budgeting.
5. What is the advantage of using certainty-equivalent cash flows instead of risk-adjusted discount
rates to calculate the NPV of an investment project?
Answer: Certainty equivalents are minimum fixed cash payments that would be accepted in lieu
of risky cash flows; the decision maker is indifferent between a risky gamble and a particular
fixed payoff. Each risky cash flow may be adjusted individually. Certain cash flows can be
discounted at the risk-free rate. The present value thus derived is equivalent to the one derived
from expected cash flows and risk-adjusted discount rates.
PROBLEMS
1. Suppose that Bethlehem Steel has a current sales level of $2.5 billion, variable costs of $2 billion,
and fixed costs of $400 million. If sales rise by 15 percent, how much will pre-tax profit increase
in dollar terms? What will be the percentage increase in pre-tax profit? What explains the
relationship between the percentage change in sales and the percentage change in pre-tax profit
for Bethlehem?
Answer: Currently, pretax profit = $2.5B ─ 2B ─ 0.4B = $0.1B. We assume that variable costs
are proportional to sales. Sales in the new year are 2.5(1.15) = $2.875B. Costs are 2.0(1.15) =
$2.3B. So, pretax profit = 2.875 ─ 2.3 ─ 0.4 = $0.175B, a 75% increase. This problem
demonstrates the potential effects of operating leverage.
2. In early 1990, Boeing Co. decided to gamble $4 billion to build a new long-distance, 350-seat
wide-body airplane called the Boeing 777. The price tag for the 777, scheduled for delivery
beginning in 1995, is about $120 million apiece. Assume that Boeing’s $4 billion investment is
made at the rate of $800 million a year for the years 1990 through 1994 and that the present
value of the tax write-off associated with these costs is $750 million. Based on estimated annual
fixed costs of $100 million, variable production costs of $90 million apiece, a marginal corporate
tax rate of 34 percent and a discount rate of 14 percent, what is the break-even quantity of
annual unit sales over the Boeing 777’s projected 15-year life? Assume that all cash inflows and
outflows occur at the end of the year.
Answer:
3. The recently opened Grand Hyatt Wailea Resort and Spa on Maui cost $600 million, about
$800,000 per room, to build. Daily operating expenses average $135 a room if occupied and $80
a room if unoccupied (much of the labor cost of running a hotel is fixed). At an average room
rate of $500 a night, a marginal tax rate of 40 percent, and a cost of capital of 11 percent, what
year-round occupancy rate do the Japanese investors who financed the Grand Hyatt Wailea
require to break even in economic terms on their investment over its estimated 40-year life?
What is the likelihood that this investment will have a positive NPV? Assume that the $450
million expense of building the hotel can be written off straight line over a 30-year period (the
other $150 million is for the land which is not depreciable) and that the present value of the
hotel’s terminal value will be $200 million.
Answer:
4. Conduct a sensitivity analysis for a project with the following characteristics. Each parameter can
take on any of three different values but once a parameter value is selected, that value remains
constant for the ten-year period. The discount rate is 10 percent and the project life is ten years.
Ignore taxes and depreciation.
Low Mean High

(1) Sales (units) 160 500 960

(2) Price (per unit) $3,000 $3,750 $4,000
(3) Variable cost (per unit) 3,000 3,000 3,000
(4) Fixed cost 100,000 200,000 4,000
(5) Initial investment 1,000,000 2,000,000 4,000,000
Answer: The problem implies that since PVIFA = 6.447, the discount rate is 8.9% per year. For the
mean case,
E[NPV] = 2,000,000 + 6.447{ 500 (3750 3000) 200,000 }

= $871,775
Sensitivity Analysis allows each variable individually to deviate from its mean value:
(e.g. 2,515,760 = 2,000,000 + 6.447{160(3750 3000) 200,000}
Variable Low High
Sales $2,515,760 $1,352,440
Price $3,289,400 $65,900
Variable Costs $871,775 $871,775
Fixed Costs $227,075 $2,161,175
5. American Fruit Co. is considering constructing a new plant to process frozen fruit juices. One
plant would be capital intensive, the other much more labor intensive. Although the final decision
would hinge on the relative cost of capital versus labor in the northern California area,
management is curious about the behavior of the plants’ return on assets during a typical business
cycle.
a. Given the following information, calculate the break-even point in units of production for the
two plants.
Answer: Q1 = F/(P ─ V) = 200,000/(2 ─ 1.50) = 400,000 units
Q2 = F/(P ─ V) = 600,000/(2 ─ 0.50) = 400,000 units
b. The economics department has prepared sales projections for three business scenarios:
recession, normal, and recovery. Sales under each scenario are expected to be as follows:
recession, 300,000 units; normal, 500,000 units; and recovery, 800,000 units. Calculate the
return on assets for the two plants under these three scenarios.
Answer: ROA = Return/Investment; for Plant 1 (Recession):
Return = 300,000(2 ─ 1.5) ─ 200,000 = ─50,000
ROA = ─50,000/1,000,000 = ─5%
Dollar Return ROA
Recession ─50,000 ─5%
Plant 1 Normal 0 0%
Recovery 100,000 10%
Recession ─150,000 ─15%
Plant 2 Normal 0 0%
Recovery 300,000 30%
c. If the three scenarios are all equally likely, what will be the variance of the return on assets
for plant 1? For plant 2? What would you advise American Fruit?
Plant 1 Plant 2
Fixed cost $200,000 $600,000

Variable cost (per unit) 1.50 .50
Price (per unit) 2.00 2.00
Investment 1,000,000 1,000,000
Answer: E(ri) = Spiri
σ2i = S pi[ri─E(ri)]2
Plant 1: E(r1) = 0.333(─5 + 0 + 10) = 1.667%
σ21 = 0.333(44.444 + 2.778 + 69.444) = 38.89
σ1 = Ö38.89 = 6.24%
Plant 2: E(r2) = 0.333(─15 + 0 + 30) = 5.00%
σ22 = 0.333(400 + 25 + 625) = 350
σ2 = Ö350 = 18.71%
Plant 2 has higher expected returns, but these returns bear more systematic risk than those of Plant
1. Also, Plant 2 is operationally more levered than plant 1. The manager needs to assess the
contribution to portfolio risk of each of the projects, and to consider the risks of operating leverage
in his decision. In particular, it seems that the portfolio risk and the total risk of plant 2 are greater;
the additional expected return may or may not be enough to compensate the firm for bearing this
risk.
6. For the following project, the chief financial officer has prepared a set of certainty-equivalent
factors to adjust the cash flows for the estimated risk. The economics department has also
prepared a set of risk-adjusted interest rates at which to discount the project’s cash flow. The
project’s initial investment is $150,000 and the Treasury security rate is 8 percent
Year 1 2 3
Cash flows ($000) $50 $75 $130

Certainty equivalents
(finance department) .982 .964 .947
Risk-adjusted rates
(economics department) 10% 12% 14%
a. What is the NPV of the project from the finance department’s estimates?
Answer: CE1(000’s) = 50(0.982) = 49.1 ┌───────────────────────────┐
CE2 = 75(0.964) = 72.3 NPV = ─C0 + S CEt/(1 + rf)t
CE3 = 130(0.947) = 123.1 └───────────────────────────┘
NPV(000’s) = ─150 + 49.1/1.08 + 72.3 /1.082 + 123.11/1.083

= $55,177.
b. What is the NPV from the economics department’s estimates?
Answer: PV(000’s) = 50/1.10 + 75/(1.12)2 + 130/(1.14)3 = $42,992
c. What would you advise the company to do?
Answer: Accept the project because it has positive net present value. The finance
department method (CEQ) may be more reliable if risk and time value are measured
consistently and separately.
7. A gold mine is considering replacement of some machinery. The new conveyor belt will cost $5
million and lower the cost of removing ore from the mine by $4 per ton. The old belt can be
scrapped for $500,000. The following table shows that the life of the new machine is uncertain,
as is the annual amount of ore that will be moved:
Low Mean High
Tons per year 200,000 250,000 350,000

Life of new machine 6 years 9 years 13 years
Conduct a sensitivity analysis of the NPV of the replacement project assuming a discount rate of 10
percent. Ignore taxes.
Answer: The analysis varies individual components while all others are valued at their means.
NPV = ─4,500,000 + 4 ´ (Number of tons) ´ (PVIFA factor)
NPV(mean) = ─4,500,000 + 4(250,000)(5.759) = 1,259,000
Low Mean High NPV(Low) NPV(High)
Ton 200,000 250,000 350,000 $107,200 $3,562,600
Life 6 9 13 ─145,000 2,603,000
PVIFA(10%) 4.355 5.759 7.103
8. Teletech Co. wants to use a decision tree in evaluating a venture capital investment in cable TV.
The projected investment has a life of three years, and the associated after-tax cash flows ($000)
and probabilities are as follows:
Year 1 Year 2
Cash flow: $100 P = .50 If cash flow in year 1 = $100

$200 P = .50 Year 2 cash flow = $120 P = .60
= $9 P = .40
If cash flow in year 1 = $200
Year 2 cash flow = $250 P = .50
= $210 P = .50
Year 3
───────────────────────────────────────────────────────────
─────────
If cash flow in year 2 = $120, can sell the investment for either $350 (P = .70) or $250. If cash
flow in year 2 = $95, can sell the investment for either $125 (P = .60) or $75.
If cash flow in year 2 = $250, can sell the investment for either $475 (P = .80) or $275.
If cash flow in year 2 = $210, can sell the investment for either $140 (P = .50) or $110.
The initial investment for the firm is $500,000 after tax. The firm uses a cost of capital of 10
percent.
a. Construct a decision tree with the expected NPV of each alternative.
Answer: Cash flows and probabilities are shown below:
Time 1 Time 2 Time 3 NPV Prob
0.70
0.60 ┌────────── 350 ─46.96 0.21
┌────────── 120 ───┤ 0.30
│ └────────── 250 ─122.09 0.09
0.50 │
┌──────── 100 ───┤
│ │ 0.60
│ │ 0.40 ┌────────── 125 ─236.66 0.12
│ └────────── 95 ───┤ 0.40
│ └────────── 75 ─274.23 0.08
│
──┤
│ 0.80
│ 0.50 ┌────────── 475 245.30 0.20
│ ┌───────── 250 ───┤ 0.20
│ │ └────────── 275 95.04 0.05
│ 0.50 │
└──────── 200 ────┤
│ 0.50
│ 0.50 ┌────────── 140 ─39.44 0.125
└───────── 210 ───┤ 0.50
└────────── 110 ─61.98 0.125
b. What is the expected NPV of the best possible outcome? What is its probability?
Answer: The best possible outcome has NPV(000’s) = $245.30. Its associated probability is
0.20.
c. What is the expected NPV of the worst possible outcome? What is its probability?
Answer: The worst possible outcome has NPV(000’s) = ─$274.23. The probability of
attaining this outcome is 0.08.
d. Should Teletech make the investment? Why or why not?
Answer: Teletech should likely not make the investment since the expected net present value
is negative.
9. Refer to the Starship project in Section 2.
a. What would the break-even quantity be initially if the cost of capital for the project were
estimated at 14 percent rather than 10 percent?
Answer:
I0 ─ D F
Q = ───────────────────── + ─────
PVIFAr,n (P─V)(1─t) P─V
250 ─ 120 15
Q = ───────────────────── + ─────── = 54.03 units.
5.2161 (2.7─1.5)(0.5) 2.7─1.5
b. What would the break-even quantity be if the Starship could be sold for only $2,000,000
each (assume a cost of capital of 10 percent)?
Answer:
250 ─ 120 15
Q = ───────────────────── + ─────── = 114.63 units.
6.1446 (2.0─1.5)(0.5) 2.0─1.5
c. What would the break-even quantity be if cost overruns increased the initial investment from
$130,000,000 to $230,000,000?
Answer:
350 ─ 120 15
Q = ───────────────────── + ─────── = 74.89 units.
6.1446 (2.7─1.5)(0.5) 2.7─1.5
10. The following exhibit contains Beech’s estimates of demand, price, and fixed and variable costs
for the Starship under three alternative economic forecasts.
Variable (per year) Pessimistic Normal Optimistic
Demand 50 75 125
Price* 2 2.7 3.2
Fixed cost* 22 15 7
Variable cost* 1.75 1.50 1.0
a. If all other variables are assumed to be at their expected value (normal forecast), how sensitive is
the project’s NPV to changes in fixed cost? Use a cost of capital of 10 percent, tax rate of 35
percent, and project life of ten years.
Answer: NPV = ─Inv + D + (Demand(Price─Var)─Fixed)(1─tax)(PVIFA)
Normal Case: NPV = ─250 + 120 + (75(2.7─1.5)─15)(0.65)(6.1446)
= $169.55M
Variable Pess Norm Opt NPV(Pess) NPV(Opt)
Demand 50 75 125 49.73 409.19
Fixed Cost 22 15 7 ─40.14 319.32
b. How sensitive is the project’s NPV to changes in price?
Answer: Variable Pess Norm Opt NPV(Pess) NPV(Opt)
Price 2 2.7 3.2 141.59 201.50
c. How sensitive is the project’s NPV to changes in variable cost?
Answer: Variable Pess Norm Opt NPV(Pess) NPV(Opt)
Var. cost 1.75 1.5 1.0 94.66 319.32
d. Which factor seems most important to the success of the plane?
Answer: Fixed costs can make the project unprofitable. The same greatest dollar variation in
NPV, however, can be achieved by changing either demand or fixed costs.
e. Is the Starship a risky project? Explain.
Answer: In the sense of total volatility, the project is risky. However, investors may be able to
diversify this risk. In the sense of guaranteeing a positive NPV, the project is not very risky; only
in one scenario will NPV become negative.
Chapter 6: Estimating the Project Cost of Capital
1. Show how the following events change the discount rate applicable to an expansion of an
existing restaurant chain.
a. The covariance between restaurant sales and the market rate of return increases.
Answer: If the covariance between restaurant sales and the market return
increases, then so must its beta, since ßi = cov(ri,rm)/σ2m. The discount rate will also
increase.
b. The riskless rate decreases.
Answer: If the risk-free rate decreases and nothing else changes, there is no reason to believe
that the beta of the firm will change. If the required rate of return on the market stays the same, a
decrease in the risk-free rate effects an increase in the market risk premium; the change in the rate
of return on the project depends on its beta. If ß>1, the rate of return on the project will
decrease; if ß<1, the rate of return on the project will increase. Alternatively, if the required rate
of return on the market drops in tandem with the risk-free rate (a likely prospect), the required
rate of return on the project will fall.
c. Several other companies are planning to expand their chains.
Answer: This action will likely reduce the expected cash flows from the project, but will
have no effect on the discount rate applied to these cash flows.
2. A large manufacturer is evaluating the purchase of a smaller firm. The firm has the same required
return as the manufacturer, estimated at 10 percent, yet its actual rate of return is about 8
percent. Although the project appears to have a negative NPV, company executives have
considered the low cost of debt financing. Because the manufacturer has no existing debt
outstanding, it may borrow at only 7 percent. Furthermore, interest deductibility and a tax rate of
50 percent lower the effective cost of debt to 3.5 percent. Because the cost of financing the
acquisition with debt is much lower than the 8 percent expected return, the executives are
considering going ahead with the acquisition. Comment.
Answer: The acquisition may have positive net present value, but only because the present value
of the financing benefits exceeds the present value of the investment losses incurred. If the
manufacturer can use the interest tax shield, it should consider the financing aspects alone, and
borrow for its own account. This proposal avoids the deadweight loss of the marginally
undesirable acquisition project. The analysis fails because it assigns the cost of capital of the
manufacturer to the smaller firm. Can the new debt be issued without recourse to the parent
company? The answer to this question is critical to the determination of the value of the project.
3. Which of the following companies is likely to have a higher beta, and thus a higher cost of
capital?
a. An auto manufacturer who runs an assembly line with union workers.
b. A “high-tech” auto manufacturer with a fully automated line requiring only a handful of
nonunion workers.
Answer: The high-tech firm has greater fixed costs and operating leverage. The inflexible cost
structure will cause greater swings in returns for a given market movement than those of its low-tech
counterpart. The high-tech beta will also be higher, yielding a higher cost of capital.
4. What impact will each of the following events have on a firm’s weighted average cost of capital?
a. The corporate tax rate is lowered.
Answer: WACC rises because the effective cost of debt, r(1 ─ t), rises.
b. The firm increases its leverage.
Answer: If the firm was operating at an optimal capital structure, an increase in
leverage will likely raise its WACC. If the firm were operating at a suboptimal capital
structure, the effect is ambiguous.
c. The firm’s stock price falls dramatically.
Answer: If the firm’s stock price falls, the value of the assets changes. However, from
this information alone, we cannot know the change in the riskiness of the assets.
Therefore, the impact on the WACC is uncertain.
d. New York City imposes a stamp tax on share issues floated there.
Answer: This increases the cost of equity, and thus raises the WACC. If all projects
are financed out of retained earnings, however, there will be no effect.
e. The government allows private investors to exclude up to $1,000 in dividends from taxable
income.
Answer: This action allows dividends a partially tax-free status, lowering the cost of
equity and the WACC. At the same time, however, companies will use less retained
earnings and will raise more new equity, forcing it to bear flotation costs.
f. The firm sells a division and replaces it with a less risky project.
Answer: The lower risk project reduces the required rate of return on assets, and thereby
reduces the required rate of return on equity, lowering the WACC. This observation does not
suggest that firms should adopt less risky projects to lower their WACC; the WACC rule
requires that firms minimize the WACC for a fixed investment policy.
5. Suppose a new investment opportunity offers a 14 percent rate of return. Is this an attractive
project to an ongoing firm if the firm can finance the project with 100 percent debt at an 11
percent interest rate?
Answer: What would the interest rate be if the project were financed on a stand-alone basis? If
the firm can finance the project at 11%, it may be the case that the lender is considering the
credit-worthiness of the firm as a whole, and not this individual project. The project’s expected
return of 14% must be compared with its required rate of return according to the project risk
alone. In other words, the cost of capital is not necessarily equal to the required rate of return.
6. A corporation has the following balance sheet (liabilities side):
Current liabilities $2,000

Long-term debt 5,000
Preferred stock 2,000
Common stock 8,000
Retained earnings 3,000
$20,000
Currently, the riskless interest rate is 8 percent; the corporate ta rate is 50 percent; the current
price of a share of common stock is $20; and dividends have been level at $1 per share per year
for many years.
Recently, company executives have considered expanding the existing business by acquiring a
competitor. To do so, they must calculate the WACC of the firm and estimate the NPV of the
acquisition. Because the acquisition is of the same risk as the firm, the WACC (unlevered equity
cost) can be used.
A financial executive has used the following procedure to calculate the WACC. Debt and
preferred are fixed claims offering a fairly secure constant return, and so their before-tax cost is
assumed to equal the riskless rate. The dividend yield has held constant at about 5 percent, so this
is used as the cost of new and retained equity. Finally, the balance sheet shows the firm to be
composed of 25 percent debt, 10 percent preferred, 55 percent equity (common plus retained),
and 10 percent current liabilities. Current liabilities are assumed to be costless; therefore the
WACC is 4.55 percent.
Comment on this procedure.
Answer: The procedure is faulty for a number of reasons. Debt and preferred shares are
not risk-free; the cost accorded these liabilities should equal the after-tax risk-adjusted
return. Furthermore, although dividends have been constant at $1 per year, the share
prices may have reflected capital gains or losses, providing a total rate of return much
different than 5%. Flotation costs were ignored. WACC should be calculated with market
values, not book values. Finally, current liabilities may not be costless.
7. “Our conglomerate recognizes that foreign investments have a very low covariance with our
domestic operations and thus are a good source of diversification. We do not ‘penalize’
potential foreign investments with a high discount rate but, rather, use a discount rate just 3
percent above the prevailing riskless rate.” Comment.
Answer: It is difficult to determine whether a penalty is being assessed or not. It can be
argued that foreign operations in general should require a lower rate of return than similar
domestic operations, but from the information given, we cannot determine the required rate of
return for domestic operations. Odds are the systematic risk is lower for foreign operations
because of low covariance with domestic assets. Foreign investments should be treated like
U.S. investments when determining the appropriate cost of capital. It is unlikely that all
foreign projects should require a rate of return equal to 3% over the risk-free rate.
8. A large food processor and distributor is considering expansion into a chain of privately
owned sports shoe outlets. The food company wishes to estimate the risky discount rate for
such investments so as to negotiate a fair price for the acquisition. Unfortunately, there are no
stock exchange-listed sports shoe companies with a price history with which a “sports shoe
outlet beta” can be estimated. However, executives are considering using the price history of
another company to estimate the beta. Which of the following companies would be the most
appropriate? Explain.
a. Another large food company.
b. A holding company for a football team.
c. A company that manufactures shoes.
d. A chain of swimwear and surfboard stores in California.
Answer: An argument may be made for both C and D. Although C is not a perfect match,
historical data from this company may provide a good estimate of beta. One could argue that
choice D also contains common risk elements, since sport shoes may be considered a luxury
sporting item, compared with shoes in general, which are considered necessary items. Since D’s
business is restricted to California, however, one would want to consider the differences between
California and national demand for sports shoes. Overall, the cost side is probably more
correlated with C, while the revenue side is probably more correlated with D. Perhaps the ideal
beta would be estimated by taking a mixture of these two.
9. When Gamma Company computes its cost of capital, it uses zero as the cost of retained
earnings.
a. Comment on this procedure.
Answer: Earnings retained as cash must earn the risk-free rate of return. Reinvested
earnings must earn the rate of return commensurate with the risk of the investment. In no
case will a zero required rate of return be appropriate.
b. How is this procedure likely to affect its investment decisions?
Answer: This procedure will likely suggest that too many projects be accepted; it
lowers the apparent WACC. Marginal projects accepted under this procedure will
have negative NPV under the correct procedure.
10. Which investment is likely to have a higher degree of systematic risk, a copper mining project
in Chile or an investment in a Brazilian auto plant whose output would be sold locally?
Explain.
Answer: The copper mining venture in Chile is likely to have a higher degree of systematic
risk. The major element of systematic risk in any extractive project is related to variations in
the price of the mineral being extracted, which is set in a world market. The world market
price is in turn a function of worldwide demand, which itself is systematically related to the
state of the world economy. By contrast, the return on an investment in a Brazilian auto plant
whose output would be sold locally would be more highly correlated with the state of the
Brazilian economy than with the U.S. or world economy. In general, a market-oriented project
in an LDC—whose risk depends largely on the evolution of the domestic market in that
country—is likely to have a relatively small systematic risk.
CHAPTER 6: PROBLEMS
1. Ampex common stock has a beta of 1.4. If the risk-free rate is 8 percent, the expected market
return is 16 percent, and Ampex has $20 million of 8 percent debt, with a yield to maturity of
12 percent and a marginal tax rate of 50 percent, what is the weighted average cost of capital
for Ampex?
Answer:
2. Calvin Inc. earned $2.00 per share during the past year and has just paid a dividend of $.40
per share. Investors forecast that Calvin will continue to retain 80 percent of its earnings for
the next 4 years and that earnings will grow at 25 percent per year through year 5. The
dividend payout ratio is expected to be raised in year 5 to 50 percent, reducing the dividend
growth rate to 8 percent thereafter. If Calvin’s equity β is .9, the risk-free rate is 8.5 percent,
and the market risk premium is 8 percent, what should its price be today?
Answer: With an estimated 25% annual growth rate, Calvin’s forecast earnings for the next 5
years are $2.50, $3.13, $3.91, $4.88, $6.10. With a 20% dividend payout rate for the first 4
years and a 50% payout rate thereafter, this earnings stream yields dividends of $0.50, $0.63,
$0.78, $0.98, $3.05. Note that the last term in the series is just $6.10 * 0.50. In year 6, the
forecast dividend is $6.10 * 1.08 * 0.50 = $3.29. This dividend is projected to grow at the rate
of 8% annually.
It is important in answering this question to consider the fact that the dividend payout rate
changed in year 5 to 50%, from 20%. Hence, just taking the initial 40¢ dividend and
multiplying it by (1.25)5 will not give you the correct answer.
To determine Calvin’s price today based on these expectations, we must next estimate Calvin’s
cost of equity capital. Using the CAPM, this figure is
ke = rf + βe(rm - rf) = 8.5% + 0.9 * 8% = 15.7%
The present value at 15.7% of the first 5 dividend payments is $3.42. The present value as of the
end of year 5 of the dividend flows from year 6 on can be found using the dividend growth model,
Po = DIV1/(ke - g). Substituting in the numbers previously calculated, we get
Po = DIV1/(ke - g) = $3.29/(0.157 - 0.08) = $42.73
The present value of this number of today is $42.73/(1.157)5 = $20.61. Adding the value of the
two cash flows gives a price for Calvin’s stock today of $24.03.
Remember that you must discount the price as of the beginning of year 6 by (1.157) 5 instead of
(1.157)6. The former is correct because you are discounting it back 5 years, not 6 years.
3. As a financial analyst for National Engineering, you are required to estimate the cost of capital
the firm should use in evaluating its heavy construction projects. The firm’s balance sheet data
and other information are listed below. Assume the corporate tax rate is 35 percent.
a. What is your estimate? What assumptions must you make to calculate this estimate?
Answer: The balance sheet liabilities (market values) along with the required after-
tax rates of return are shown below:
Item Mkt Value (000’s) Req’d Rate
Accounts Payable $200 0.00%
10-Year Debt 250 12% ´ (1 ─ 0.65) = 7.80%
15-Year Debt 1000 15% ´ (1 ─ 0.65) = 9.75%
1-Year Debt 250 11% ´ (1 ─ 0.65) = 7.15%
Preferred Stock 450 4.50/22.50 = 20.00%
Common Stock 4725 7% + 10% = 17.00%
Total/Wtd Avg $6875 14.95%
Assumptions:
i. Accounts payable have the same average risk as short-term debt, but no cost (i.e. built
into price).
ii. Average price is a good estimate of current market value.
iii. The riskiness of the firm has not changed substantially; the historical data provide
accurate estimates of future risk and return.
Note: Stock will normally earn a higher average return than preferred.
b. What qualifications to this estimate should you mention in your report when National
applies this rate to its various projects?
Answer: In using this estimate of the WACC, the firm should be careful not to
apply this discount rate to projects whose risks are not comparable with that of the
firm as a whole. Project required return rates depend on the market risk of the
projects, not the overall risk or credit-worthiness of the firm.
Selected Balance Sheet Items Market Data
Market Value Yield

(bonds)
Bonds (see market data) Bonds

Preferred stock $400,000 8%, 10-year $250,000 12%
Common stock $800,000 12%, 15- $1,000,000 15%
Retained earnings $2,000,000 year $250,000 11%
21%, 1-year
Common stock:
Average dividend growth (5 years) = 10%
Current dividend yield = 7%
Price = $47.25
Shares = 100,000
Preferred stock:
$4.50 preferred dividend
Price = $22.50
Shares = 20,000
4. A corporation’s securities have the following betas and market values:
Market
Beta Value
Debt .1 $100,000
Preferred .4 200,000
Common 1.5 100,000
Calculate the following figures given a riskless interest rate of 10 percent and market risk
premium of 5 percent:
a. discount rates for each security.
Answer: Debt discount rate rD = 10 + 0.1(5) = 10.5%
Preferred discount rate rP = 10 + 0.4(5) = 12.0%

Common discount rate rE = 10 + 1.5(5) = 17.5%
b. the asset beta for the corporation.
Answer: The asset beta is the market-weighted average beta of the assets, which is
equivalent to the market-weighted average beta of the liabilities (ratio terms in
000’s):
ßA = 0.1(100/400) + 0.4(200/400) + 1.5(100/400) = 0.60
c. the weighted average cost of capital.
Answer: WACC = 0.105(0.25) + 0.12(0.50) + 0.175(0.25) = 13.0%

d. the discount rate for the unlevered assets.
Answer: The discount rate for unlevered assets whose business risk is the same as
that of the firm as a whole is exactly equal to the weighted average cost of capital, or
13.0%.
5. As part of its efforts at diversification, the Sherbert theater organization, producer of
Broadway plays, is considering acquiring a movie theater chain. A prime acquisition candidate
is Consolidated Cinemas, currently owned by a conglomerate, Tryon. Although Tryon has
given Sherbert what it feels is an accurate forecast of expected cash flows from the cinema
chain, Sherbert would like to have its own estimate of the required rate of return to apply to
these cash flows. The chief financial officer has acquired the following information on
independently owned movie house chains:
Movie House Beta D/TA*
NCO Theater, Inc. 1.70 .40

Worldwide/Global .50 .10
Screen Rocks 2.50 .50
Ultimate Theater -.10 .75
a. Using a risk-free rate of 7.5 percent and a market risk premium of 8.5 percent, what is
your estimate of the cost of equity capital for Consolidated?
Answer: We assume that the debt is risk-free, and that the betas shown in the table
are equity betas. Then the asset betas can be found with the following equation: ß A
= ßE[E/TA], where TA = total assets = D + E. Asset betas appear below:
NCO Theater, Inc. 1.70(1 ─ 0.40) = 1.020
Worldwide/Global 0.50(1 ─ 0.10) = 0.450
Screen Rocks 2.50(1 ─ 0.50) = 1.250
Ultimate Theater ─0.10(1 ─ 0.75) = ─0.025
The average asset beta is 0.67375, so the required rate of return is 7.5 + 0.67375(8) =
12.89%.
b. What qualifications would you include with your estimate?
Answer: The quality of the estimate is limited by the extent to which these four
companies can serve as proxies for Consolidated Cinemas. The betas seem quite
different, indicating that the assumption may be questionable. A second doubt
concerns the source of the betas. If the betas were derived from historical
relationships, are those relationships still valid? If they were derived from subjective
data, what assumptions were made in the calculations?
6. Westcon is considering building a facility to tap thermal energy using wind power. Part of the
project’s cost, $750,000, can be financed with a loan from the Federal Energy Commission at
the below-market rate of 5 percent. The remainder, $250,000, can be financed with an
industrial revenue bond at 10 percent. Current debt rates for Westcon are 15 percent. The
project should generate pre-tax net profit of $425,000 a year for ten years. Westcon has a 40
percent tax rate, and the D/E ratio is .50. Westcon estimates that the project beta is 1.50 and
forecasts a risk-free rate of 10 percent for the life of the project. The market rate is estimated
to be 20 percent.
a. Should Westcon undertake the project?
b. Assuming the project is of the same risk as Westcon itself, would the project be acceptable
without the subsidies? Explain.
Answer: This is a very difficult problem. Two sets of answers appear below. The first
answer takes a simple approach to problem solution when annual cash flows are $1.5M and
the tax rate is 40%. The first answer assumes that no debt is displaced.
The second answer analyzes the problem when cash flows are $300,000 per year, and the
tax rate is 50%. The second solution assumes that debt is displaced, and demonstrates the
equivalence of the WACC and the APV approach in decision-making.
Version 1
We assume there is no investment tax credit and no depreciation. In the absence of
favorable financing terms, cash flows include an initial outlay of $1M, and annual after-tax
cashflows of $1.5M(1 ─ 0.40) = $0.9M. Since the project beta is 1.5, the required rate of
return is rp = rf + ßp(rm ─ rf) = 10 + 1.5(10) = 25%. The present value of these cash flows is
$3.213M ─ 1M = $2.213M.
a. We now add debt to the analysis. We assume debt is risk-free. From equation 9.11, we
need to find the adjusted net present value (APV), which takes into account the present
value of tax shields and favorable financing terms. Note that since the 15% debt rate
applies to the company as a whole, we cannot use it in this project analysis.
Assume that both loans (250K and 750K) will make annual interest payments and
repay principal following the ten year project life. Tax savings in each year will then
be: 250,000(0.10)(0.40) + 750,000(0.05)(0.40) = $25,000.
The present value of the tax savings (assuming these savings are risk-free) is
$25,000[PVIFA(r=10%,10 yrs)] = $153,614.18 = $0.154M.
The FEC loan subsidy amounts to a subsidy of (0.10 ─ 0.05)(750,000) = $37,500 per
year for 10 years. If this is risk-free, the present value is $230,421.27 = $0.230M.
APV = $2.213M + 0.154M + 0.230M = $2.597M.
Westcon should undertake the project (APV>0).

b. If the project were the same risk as Westcon itself, it should likely be accepted. The exact
weighted average cost of capital of Westcon cannot be determined from the given
information. However, as long as WACC<89.85%, the project should be accepted.
Version 2
Assume that annual operating cash flows are $300,000, and the marginal tax rate is 50%.
Ignore depreciation. These changes are reflected in some printings and not in others.
There are two basic approaches that you can take to solve this problem and they both give
similar answers. One approach is to use the adjusted present value (APV) and value the
project on an all-equity basis and then separately value the tax advantages of debt and the
interest subsidy. The other approach is to use a weighted average cost of capital (WACC)
ignoring the subsidized financing but taking into account the tax deductibility of debt and
then separately value the interest subsidy.
APV Approach
APV = NPV of project if all-equity financed

 NPV of financing side-effects caused by project acceptance
APV = ─I0 + S CFi/(1 + k*)i + S Ti/(1 + r)i + S Si/(1 + r)i
where k* = the all-equity cost of capital
CFi = the after-tax operating cash flow
Ti = tax savings in period i resulting from the specific financing package
Si = before-tax dollar value of interest subsidies in period i resulting from project-specific
financing
r = before-tax cost of unsubsidized debt
The latter two terms in the equation above are discounted at the before-tax cost of debt to
reflect the relatively certain value of the cash flows resulting from interest tax shields and
interest savings.
To apply the APV, we first have to calculate the all-equity cost of capital. This figure is k* =
rf + ßa(rm ─ rf), where ßa is the asset beta for the project. Substituting in the numbers given
in the problem yields k* = 25%.
The after-tax operating cash flows (we are ignoring depreciation in this problem) are
$300,000 (1 ─ 0.50) = $150,000.
The debt capacity of the new project is $333,333, given Westcon’s target debt:equity ratio
of 0.50. However, Westcon is adding $1 million in debt. This means that the new debt is
displacing $666,667 in 15% debt elsewhere in Westcon’s capital structure.
The tax savings on the added debt equal the value of the interest write-off in the $1 million
in new debt minus the lost tax shield on the $666,667 in 15% debt that is displaced by the
new debt. That is, the interest tax shield is worth 0.5[750,000 ´ 0.05 + 250,000 ´ 0.10 ─ 0.15
´ 666,667] = ─$18,750. The negative figure means that the tax shield on the displaced debt
exceeds the tax shield on the low interest debt. This should not be surprising: consider
what the tax shield would be on debt that carried a zero interest rate. Clearly, the benefits
of the interest subsidy don’t show up in the form of a tax write-off; but they do show up in
the interest subsidy figure.
The before-tax value of the interest subsidy is 750,000(0.15 ─ 0.05) + 250,000(0.15 ─ 0.10) =
$87,500. Hence, the total value of the specific financing package, taking into account both
the tax benefits of debt and the interest subsidy that Westcon receives, is $87,500 ─ $18,750
= $68,750.
Now we can calculate the APV:
APV = ─$1,000,000 + S 150,000/(1.25) i + S 68,750/(1.15)i
= ─$1,000,000 + 535,575 + 345,040 = ─$119,385.
The project is not acceptable, even with the financing subsidy.
WACC Approach
In this approach, we first value the project ignoring the financing subsidy. To do this, we
must calculate the WACC ignoring the interest subsidy, which we use to discount the after-
tax operating cash flows of $150,000 annually. Then, we estimate the value of the interest
subsidy and subtract this figure from the project NPV.
To calculate the WACC, we must estimate the levered cost of equity capital, which requires
that we calculate the levered equity beta. We can calculate the levered equity beta using
the formula
ße = ßa[1 + (1 ─ t)D/E]
Assuming that the project’s debt capacity is the same as Westcon’s debt capacity, because
the risks are assumed to be the same, we can substitute in the figures given in the problem
and get
ße = 1.5[1 + 0.50 ´ 0.50] = 1.875.
The resulting cost of equity capital, given a debt:equity ratio of 0.50 is 28.75% (10% +
1.875 ´ 10%).
The WACC, ignoring the interest subsidy (which we will calculate separately) is
2/3 ´ 28.75% + 1/3 ´ 15.00% ´ 0.50 = 21.67%
The project NPV, discounted at the 21.67% WACC, equals
NPV = ─$1,000,000 + S 150,000/(1.2167) i = ─$405,163.
The NPV of the interest subsidy can be calculated using the following reasoning. Westcon
must pay $62,500 in interest annually for the next ten years and then repay $1 million
principal at the end of ten years. In return, Westcon receives $1,000,000 today. Given
these cash inflows and outflows, we can calculate the loan’s NPV just as we would for any
project analysis. Note, however, that unlike the typical capital budgeting problem we
examined, the cash inflow occurs immediately, and the cash outflows later. The principle is
the same, however. We now need to know the required return on this project and
Westcon’s marginal tax rate.
The required return is based on the opportunity cost of the funds provided: the 15% rate
that Westcon would have to pay to borrow $1M in the capital market. We are told that
Westcon’s marginal tax rate is 50%. The after-tax required return will be 7.5% and the
after-tax interest payments will be $37,500. Now we can calculate the NPV of Westcon’s
financing bargain:
NPV = $1,000,000 ─ S $37,500/(1.075) i ─ $1,000,000/(1.075)10
= $1,000,000 ─ 699,696 = $300,304.
Alternatively, you could just calculate the present value of the ten-year annuity consisting
of the annual after-tax interest savings of 0.50 ´ $87,500 = $43,750. This annuity,
discounted at the 7.5% after-tax cost of debt financing, equals $300,304.
Adding together the project NPV with the financing NPV yields a total project value of
─$405,163 + $300,304 = ─$104,859. The WACC approach gives the same answer as the
APV approach: the project is not acceptable.
Although in theory the two approaches should yield identical quantitative results, they
don’t in practice. The difference stems from the slightly different effects of adjusting the
numerator in one case for taxes and the denominator in the other case.
7. In analyzing the possible placement of their first fast-food fish restaurant overseas, the Gill
Corp. has the following data:
Correlation of Rate of Return United States with

on Common Stock Indexes, Last Ten Years
.44 France
.75 Canada
.75 Japan
.61 United Kingdom
.27
Italy
The CFO for Gill reasons that the beneficial effect of foreign diversification should be included in
the financial analysis, by multiplying the risk of equity capital by this correlation. With a U.S. beta
of 1.15, what would the project’s beta be under this system? Is this a defensible procedure to use?
Answer: Country Adjusted Beta
France 0.506
Canada 0.863
Japan 0.633
United Kingdom 0.702
Italy 0.311
The procedure is indefensible. While the diversification benefits of foreign investment are
real and should be considered in project analysis, this ad-hoc procedure will not determine
the appropriate project betas for capital budgeting purposes. The procedure seems to
confuse country risk with project risk.
8. Tom Swift Company has a target capital structure of 40 percent debt and 60 percent equity.
Its estimated beta is .9. Tom Swift is evaluating a new project that is unrelated to its existing
lines of business. However, it has identified three proxy firms exclusively engaged in this line
of business. The average beta for these firms is 1.2, and their debt ratios average 50 percent.
Tom Swift’s new project has a projected return of 11.9 percent. The risk-free return is 10
percent and the market risk premium is 5 percent. All firms have a marginal tax rate of 40
percent. Tom Swift’s before-tax cost of debt is 13 percent.
a. What is the unlevered project beta?
Answer: The project’s unlevered beta can be found with the relation:
ßa = ße { E/[(1─t)D + E] } = 1.2 (0.5/0.8) = 0.75.
b. What is the beta of the project if undertaken by Tom Swift, assuming the company
maintains its target capital structure?
Answer: Inverting the relation in (a):
ße = ßa [ 1 + (1─t)D/E ] = 0.75 [1 + (0.60)(0.40)/(0.60)]
= 1.05
c. Should Tom Swift accept the project?
Answer: The required return is 10 + 1.05(5) = 15.25%. WACC = 12.27%. This
exceeds the expected return of 11.9%. The project should be rejected.
9. The following are the beta estimates from Value-Line for several computer firms as well as the
D/TA for the firms. Suppose the risk-free rate of return is 8 percent, the expected market
return is 17 percent, and the tax rate is 35 percent.
Company Beta D/TA
Apple 1.70 0
Amdahl 1.55 .31
Burroughs 1.00 .24
Commodore 1.50 .14
Cray 1.45 .05
Sperry 1.25 .23
Tandem 1.60 .03
a. What risk premium must these companies pay as a result of leverage?
Answer: Recall that ßa = ße { E/[(1─t)D + E] }

ße D/TA ßa k* ke(ke─k*) PCT
Apple 1.70 0 1.70 23.30% 23.30% 0.00% 0.00%
Amdahl 1.55 0.31 1.20 18.76% 21.95% 3.19% 14.54%
Burroughs 1.00 0.24 0.83 15.45% 17.00% 1.55% 9.13%
Commodore 1.50 0.14 1.35 20.19% 21.50% 1.31% 6.09%
Cray 1.45 0.05 1.40 20.61% 21.05% 0.44% 2.08%
Sperry 1.25 0.23 1.04 17.40% 19.25% 1.85% 9.62%
Tandem 1.60 0.03 1.57 22.11% 22.40% 0.29% 1.29%
The returns ra and re are calculated from the CAPM relationship, ri = rf + ß(rm─rf). The
premium due to leverage is reflected by the difference in the last column
b. What proportion of their total equity cost is a result of financing?
Answer: Proportional part of return represented by the leverage premium
PCT
Apple 0.00%
Amdahl 14.54%
Burroughs 9.13%
Commodore 6.09%
Cray 2.08%
Sperry 9.62%
Tandem 1.29%
10. In late 1984, Sonat, the Birmingham, Alabama-based, energy and energy services company,
ordered six drilling rigs that can be partly submerged from Daewoo Shipbuilding, a South
Korean shipyard. Daewoo agreed to finance the $425 million purchase price with an 8.5-year
loan, at an annual interest rate of 9 percent paid semiannually. The loan principal is repayable
in 17 equal semiannual installments ($25 million every six months). At the time the loan was
arranged, the market interest rate on such a loan would have been about 16 percent. If Sonat’s
marginal tax rate (federal plus state corporate taxes) was 50 percent at the time, how much
would this loan be worth to Sonat?
Answer:
Chapter 7: Corporate Strategy and the Capital Budgeting Decision
1. One highly recommended approach to picking stocks is to select companies that have
dominant market shares or, better yet, monopolies in their businesses. Do you think this
approach to picking stocks is likely to be successful? Why?
Answer:
2. With the advent of cable television, various new stations are entering into the broadcasting
market. Many are attempting to serve a specialized segment of viewers: the all-movie channel,
all-sports, all-music. Assume that you acquired sufficient financial backing to enter this
market. What segment do you feel is not yet being served? In what way could you
differentiate your product to add value—value for which the customer would be willing to pay
a price?
Answer: Answers will vary. For example, given a vocal minority that believes television
rots prepubescent brains (and necessarily, therefore, postpubescent ones), one could
imagine a latent demand for quality educational television. While educational television
has suffered in the past from low budgets and no-name educators, the educational
channel of the future might feature Eddie Murphy giving lectures on futures trading
and Michael Douglas teaching the power of the invisible hand (“Greed is good.”). One
could imagine nonfinancial classes as well. To add value to the concept, we should be
prepared to erect significant barriers to entry. For example, we could contract with
guilty stars who feel that education should be stressed; they can provide low cost labor.
Advertisers will feel that they can target their audiences much more accurately. One
could offer “video transcripts” or examinations through the mail to viewers who wish to
learn more or less thoroughly at a more or less rapid pace. We could create a video-tape
distribution system through an existing movie production house to video stores and
book stores. We might also establish ourselves as a purchaser of quality educational
video materials; subcontractors would thereby help us build and maintain our
educational videotape library; these reserves would be difficult for a competitor to
match. Finally, we might secure proprietary government subsidies to develop courses in
comparative economic systems.
3. One of the competitive advantages mentioned in the chapter is the experience of a firm’s
managers. GM is trying to diversify away from producing only automobiles and has been
acquiring a financial interest in firms in other product areas. To what other lines of business
might GM’s managerial experience be applicable? Do you think GM is likely to be successful
in a diversification strategy? Why?
Answer: If the hypothesis is correct, GM’s managers should be able to extract value
from their managerial services in many ways. Knowledge specific to the automobile
industry may be applicable to the production of other types of heavy machinery and
transporting devices. Experience in a market constantly threatened from the outside
may be valuable in serving other threatened markets. Finally, an understanding and
expertise in automotive distribution channels may transfer to other products with
similar distribution characteristics. However, GM had unsatisfying experiences with
the acquisition of Hughes and EDS. If their management of the auto business is not
stellar, how can they expect to provide a comparative advantage outside the auto
business?
4. Describe the investments made by the following companies mentioned in the chapter that
enabled them to pursue their business strategies: Dell Computer, Nalco Chemical, Canon,
Southwest Airlines.
Answer: Answers will vary. For example, the author makes extensive use of Post-It
Notes, manufactured by 3M. These notes temporarily adhere to research papers and
pages of the instructor’s manual, and provide varying capacity for poignant comments.
3M’s advantage is effectively guaranteed by three factors: technical innovation, brand-
name recognition and patent protection. Competitive responses are many in number.
For example, competition could wait for the patent to expire, and then flood the market
with similar note sheets. In the patent process, 3M must divulge key information
pertinent to the manufacture of Post-It Notes. With any luck for 3M, they will have
made Post-It Notes obsolete by that time. Other competitive responses might address
the function served rather than 3M’s solution to the problem. For example, one might
be able to develop ink that disappears under exposure to ultraviolet light (for temporary
notes on manuscripts) or “Corners”, non-adhesive sheets of paper cut to fit over the
corners of manuscript pages and provide space for comments. Corners might be
produced at a lower cost than 3M Post-It Notes.
5. One of the more successful strategies in retailing has been the development of “designer label”
lines of apparel. In what ways does a designer suit differ from its equivalent purchased from a
discount chain? Is this the result of advertising, quality, or some other factors?
Answer: It is possible that no qualitative differences exist between designer and generic
labels; clearly, generic producers will extol this view. However, several factors may
make the designer product superior. For example, the advertising expense may be
taken as a signal of superior quality; a well-reputed company or designer is willing to
stake its good name on the performance of the product. In the event of a product
failure, the designer company may be willing to recall the product and live up to its
claims; a generic manufacturer may opt for bankruptcy instead. Finally, image creation
may lead to a perceptive differentiation of the designer product. If the customer truly
believes she is happier, shouldn’t she be willing to pay more for the product?
6. Each community has some monopoly suppliers. Common instances are the regulated
monopolies: utilities, cable TV systems, local radio and TV stations. Other companies are
monopolies through other means: fast-food franchises, newspapers, car dealerships. Which
monopolies in your community are profitable? Why?
Answer: An example in Los Angeles is afforded by the L.A. Times. Although the Times
has nominal competitors, none seem to effectively serve all areas of the Los Angeles
market. Part of the L.A. Times’ success may have resulted from its ability to develop
and maintain a large marketing and distribution system; the prospect of duplication
likely appears daunting to potential competitors. However, some competitors have
managed to target and serve particular areas like Orange County and the San
Fernando Valley; papers there are geared toward local news.
Economies of scale in production would be hard to match with smaller production runs.
Also, the costs of contacting and persuading advertisers to use an alternative medium
would be high; with an initially small circulation base, solicitation would be costly
(lower acceptance rates per sales agent), and discounts would likely have to be offered to
encourage advertisers (reducing short-run revenue). Finally, although the L.A. Times is
profitable, margins are not likely to attract many competitors.
7. Suppose a capital goods manufacturer brings out a new, more efficient machine.
a. If the manufacturer holds a patent on this machine, who is likely to benefit the most from
it? Explain.
Answer: In a typical scenario, the manufacturer is likely to benefit most from the
patent. However, in the process of securing the patent, the manufacturer is forced to
divulge critical information to justify the issuance of a patent. If competitors can
produce close substitutes different enough to avoid the scrutiny of patent law
enforcement, then the manufacturer will enjoy little benefit from the patent.
Perhaps he would be better off not obtaining a patent in this situation.
b. Who will benefit most from this machine if the technology underlying the machine is not
proprietary? Explain.
Answer: If the technology is not proprietary, replicating firms will benefit most;
they will not have to incur the attendant research, development and legal costs
associated with developing the new product and securing a patent. Consumers will
benefit.
c. What are some of the things the manufacturer can do to earn higher returns from this
machine even without patent protection?
Answer: The manufacturer has likely reduced the marginal cost of innovation
through his development of a patentable product. While a particular product may
be copied, and his current competitive advantage is usurped, he has likely made it
possible to develop a later proprietary technology from which he can reap greater
rewards.
8. How sustainable is a competitive advantage based on technology? On low cost labor? On
economies of scale?
Answer: Technology A competitive advantage based on technology may be sustainable
if the technology is not easily reproducible. However, competitors can often usurp the
advantages of innovation by offering look-alike imitations of the parent product.
Low Cost Labor A competitive advantage based upon access to low-cost labor likely
cannot be sustained. Competitors often have the same access to these labor markets.
Economies of Scale Competitive advantage based on economies of scale are often
difficult to capture. Given a finite market size, duplication of production levels may
drown both the incumbent and the competing firm. In some cases, however, strategic
acquisitions can often give a smaller firm access to the same economies of scale a larger
firm might enjoy. As markets grow, more competitors can take advantage of the scale
economies.
9. Goodyear Tire and Rubber Company, the world’s number 1 tire producer, is competing in a
global tire industry. To maintain its leadership, Goodyear has invested over $1 billion to build
the most automated tire-making facilities in the world and is aggressively expanding its chain
of wholly owned tire stores to maintain its position as the largest retailer of tires in the United
States. It has also invested heavily in research and development to produce tires that are
recognized as being at the cutting edge of world-class performance. Based on product
innovation and high advertising expenditures, Goodyear dominates the high-performance
segment of the tire market; it has captured nearly 90 percent of the market for high-
performance tires sold as original equipment on American cars and is well represented on
sporty imports. Geography has given Goodyear and other American tire manufacturers a giant
assist in the U.S. market. Heavy and bulky, tires are expensive to ship internationally.
a. What barriers to entry has Goodyear created or taken advantage of?
Answer: Goodyear has erected several barriers to entry. First, Goodyear’s control
of a critical distribution channel locks out competition. Learning curve ascension
and large production runs gain access to economies of scale. Investment in
technological production facilities offers valuable options on future production
technology; often, computerized production facilities need only be reprogrammed,
and not completely refit. Goodyear has integrated vertically, securing proprietary
access to important distribution channels. Significant investments in research and
development signal to clients that Goodyear intends to innovate and make tires for
many years to come. A reputational barrier is difficult to erode. Finally, by
exhaustively serving a well-defined niche, Goodyear discourages competitive entry.
b. Goodyear has production facilities throughout the world. What competitive advantages
might global production provide Goodyear?
Answer: Since tires are bulky and expensive to ship relative to their profit margins,
Goodyear has found it advantageous to locate production facilities near the ultimate
points of sale. This reduces the marginal distribution costs, and provides a
significant barrier to competitive entry. Goodyear can exploit product and process
advantages across a broader market area.
c. How do tire-manufacturing facilities in Japan fit in with Goodyear’s strategy to create
shareholder value?
Answer: Japan is a leading automobile producer, with an eye on quality and
consistency. To Japanese auto producers, without a comparative advantage in tire
production, Goodyear seems a natural tire supplier. The action also serves as a
warning to potential Japanese competitors like Bridgestone in the U.S. By locating
production facilities in Japan, Goodyear reduces its marginal costs of production as
well. Also, Japanese auto producers want to upgrade their top notch models;
Goodyear can supply tires for these cars also. Finally, Goodyear wants to service
Japanese car companies producing in the U.S. By selling tires to the Japanese
manufacturers in Japan, Goodyear can gain their confidence and later U.S.
business.
d. In early 1988, Japan’s Bridgestone Corp. acquired Firestone Tire & Rubber Co. What
possible motives might Bridgestone have had for this acquisition?
Answer: Bridgestone may have thought that synergistic gains could accrue from the
merger. A few explanations are possible. The combined entity may be able to keep
Japanese customers who are now building up to 2M cars annually in the U.S. Or, if
Goodyear were charging quasi-monopolistic prices, Bridgestone may have been able
to offer Firestone the opportunity to capture some of these rents. For example,
Bridgestone provided Firestone access to a tough Japanese market it might not have
been able to enter alone. Also, R&D expenditures can be amortized over a larger
base; the merger provides a means to enter the U.S. market quickly, and on a large
scale.
e. How will Bridgestone’s acquisition of Firestone affect Goodyear? How might Goodyear
respond to this move by Bridgestone?
Answer: It seems the acquisition would affect Goodyear adversely (see part (d)).
Goodyear might counter-attack with price cuts in Japan, innovation, guarantees, or
any number of responses. It must sustain its current competitive advantages and
seek to develop new ones.
10. Borden, already the world’s largest dairy company, has made over 40 acquisitions in recent
years to become the world’s largest producer of pasta and the second-largest snack seller in
the United States. Its basic strategy is to string together a network of regional pasta, dairy,
and snack food companies to try to take advantage of various operating and marketing
efficiencies.
a. What operating and marketing efficiencies might Borden be able to take advantage of
through its acquisition strategy?
Answer: First, by acquiring small niche products, Borden builds an image of
capturing and serving entire small markets well. It enjoys efficiencies of scope in
manufacturing, and is able to save advertising expenditures by swallowing up
competitors. However, the main advantage seems to be an effective distribution
system that allows Borden to drop new products onto the truck; it can distribute
new novelty grocery and snack products quickly, effectively, and cheaply.
b. What valuable options does Borden’s acquisition strategy create?
Answer: Borden creates advantages of pre-emptive entry through its acquisition
strategy. Small competitors may buckle at the thought of competing with Borden’s
distribution system, while Borden retains the low cost option to add new products to
its distribution network. Large competitors may find the individual niches too small
for effective and profitable entry. Access to the capital markets may be easier and
cheaper for a large company; a small competitor would suffer a financing cost
disadvantage. Also, Borden retains the ability to quickly introduce or discontinue
new products without disrupting its distribution channels (a first-mover advantage).
c. Borden’s brand of processed lemon juice, ReaLemon, was the first in the market. What
advantages might Borden be able to realize by being the pioneer in this business?
Answer: Besides entering the market first, Borden immediately adopted large-scale
production facilities, efficient distribution, and a reputation for quality. ReaLemon
attracted a premium of 50% over identical competing brands because as the pioneer,
it benefited from consumer risk aversion: lemon juice doesn’t cost very much and
you don’t buy it very often, so why take a chance with an untried brand? Also,
supermarkets don’t want to allocate shelf space to more than one brand for a small
product. Competitors who considered entry likely found these barriers
insurmountable.
11. Premier Industrial Corporation is a Cleveland-based distributor of extremely humdrum
products—nuts and bolts, batteries, circuit breakers, and lubricating oil. When other
distributors peddle the same products, they operate on thin margins and aspire to get rich on
volume. Hence, they tend to carry only the fast-moving items. Premier, by contrast, carries
just about every type of component and delivers small orders in an incredibly short time. Most
of its profits come from the small maintenance and repair accounts that competitors regard as
a nuisance. The average order size is $100 (competitor orders average $400), and Premier
gets referrals from other distributors who don’t want to be bothered by small orders.
Premier’s pre-tax margins run to around 18 percent, in contrast with competitor margins of
about 1 to 2 percent.
a. What is Premier’s strategy for creating value?
Answer: The strategy is manifold. Identify superior products that are reliable and
easy to use; this serves as a quality assurance for retailers. Locate hard-to-find and
specialty items; other distributors prefer to ignore this seemingly low-profit end of
the business. Create a large enough selection of hardware products that allow the
distributor to become the “Sears of industrial accounts.” No competitor will find it
profitable to copy on a small scale, and the market may not be large enough to
support two major competitors. Finally, build-in valuable options for future
expansion in the distribution of electronics components and employ computer-based
marketing strategies.
b. Why does Premier have such high profit margins for its industry?
Answer: High profit margins resulted from the strategy points outlined in (a). In
particular, it is never necessary to cut price to increase sales; Premier provides a
unique high quality service to its retail customers. Margins persist because of
Premier’s ability to sustain its competitive advantages.
12. For each of the following companies, assess the sustainability of its competitive advantage.
a. Analog Devices, which develops specialized applications for analog semiconductors, has
invested countercyclically to cash in on business upturns. The results: 80 percent faster
growth and 50 percent higher profitability than the rest of the semiconductor industry.
Answer: For more information, consult the Harvard Business Review, September-
October 1986, p. 53-58, “Sustainable Advantage” by Pankaj Ghemawat. The
answers below are taken from that article.
Unsustainable. Existing competitors seem set to copy Analog’s investment policy,
and new ones—notably the Japanese—are invading its profitable niches.
b. Nike’s leadership in athletic shoes is built on cheap Far Eastern labor and massive
investments in product development and marketing. Over the five years between 1981 and
1986, Nike averaged three times the profitability and four times the growth of the rest of
the U.S. shoe industry.
Answer: Unsustainable. Competitors are busy cloning Nike’s strategy. Reebok

International, for one, sources 95% of its shoes from South Korea, spends heavily on
product styling, and has won endorsements from rock stars as well as athletes.
Reebok’s sales and profits expanded fivefold in 1985, while Nike’s actually declined.
Also, the market is large enough to support new competitors.
c. Lincoln Electric has been the leader in the electric welding industry ever since John
Lincoln invented the portable arc welder in 1895. Since then, technological change has
been incremental. Lincoln has integrated backward, customizing its production machinery
and holding annual worker turnover to under 3 percent. It has grown more rapidly than its
competitors, partly by sharing its cost reductions with customers.
Answer: Sustainable. As the product pioneer, Lincoln had a first-mover advantage;

that lead has proved durable because of the incremental nature of technological
change. Lincoln also has kept its experience proprietary by integrating backward,
customizing its production machinery, and holding annual worker turnover under
3%. Finally, it has continued to invest in experience by sharing cost reductions with
customers. Competitors complain publicly that they have trouble matching
Lincoln’s prices, let alone undercutting them. (See Chapter 11 for a discussion of
Lincoln’s incentive system.)
d. DuPont is a leading producer of titanium dioxide, largely thanks to a production process
based on low-cost feedstock that gives it a 20 percent cost advantage over competitors’
processes. Mastering the cheaper feedstock technology can be accomplished only by
investing $50 million to $100 million and several years of testing time in an efficiently
scaled plant.
Answer: Sustainable. Thanks to a production process based on low-cost feedstock,
DuPont enjoyed a 20% cost advantage over competitors’ processes. Mastering the
cheaper feedstock technology was a black art—it could be accomplished only by
investing $50 million to $100 million and several years of testing time in an
efficiently scaled plant. The cost and risk of this alternative kept DuPont’s
competitors from trying to imitate its demonstrably superior technology.
e. Tandem Computer pioneered fault-tolerant computers for processing transactions.
Although the cost of adding additional processing capability once a system is up and
running is relatively low, customers must first make sizable and irrecoverable system-
specific upfront investments in software and training.
Answer: Sustainable. Tandem has gained preferential access to demand for
upgrades and replacements because changeovers from one system to another are
very costly.
13. For the past two decades, Cincinnati Milacron, the largest U.S. machine tool manufacturer,
has led the U.S. machine tool industry in both R&D and the size of its sales and service
network, activities that account for about a third of the value added by the industry. In the
1980s it moved into robotics in a big way. How does this move fit into its strategy for creating
value?
Answer: The strategy clearly creates value if Cincinnati Milacron can apply
proprietary cost-saving technologies to the production of robotic equipment.

Alternatively, the strategy may be a competitive survival response to an unavoidable
manufacturing trend; it may preserve rather than add value. If Cincinnati Milacron
cannot benefit from production knowledge, its ties with clients and consistent
reputation for innovation will combine to add value from the marketing side of the
operation.
14. Super-Valu Stores, Inc., is the nation’s largest and most efficient grocery wholesaler and
distributor. For example, Super-Valu has cut costs by raising storage density in its warehouses
while minimizing the time and travel distance it takes workers to find and retrieve the goods.
Using as many as 1,400 separate measurements, the company has been collecting data for
over ten years on how both workers and wares move throughout the system. Industrial
engineers have measured the capacity of each rack layout in each warehouse down to the
square inch. A computer assigns “slot positions” to the incoming merchandise and tells the
workers the order in which to pick cases for delivery. The data are then fed into a simulation
program that analyzes and optimizes the productivity and storage capacity of various
warehouse arrangements, given the merchandise to be stored.
a. What is Super-Valu’s strategy for creating value?
Answer: Value creation seems to stem principally from Super-Valu’s ability to use
the wholesale grocery business as a base to integrate vertically. It has the ability to
put an aggressive retailer on equal footing with big grocery chains, and allows the
small retailer to specialize in retail. In particular, Super Value provides market
evaluation, site selection, design, wholesaling, and retail counseling services to the
small retailer. Together with the retailers, Super-Valu has been able to help capture
small markets and build solid reputations. Also, its own efficiencies in warehousing
and delivery offer savings to the entire distribution channel.
b. How sustainable is Super-Valu’s competitive advantage?
Answer: The advantages seem to be sustainable. While competitors may be able to
duplicate Super-Valu’s strategies in other markets, they likely will find attacks on
existing markets unprofitable. To the extent that Super-Value can retain its
innovative edge, it can be assured that their competitive posture will remain intact.
15 Avis has invested a large amount of money to spread the message that “We’re Number Two
and trying harder.” Number One in the rental car industry, of course, is Hertz. How did Avis’s
investment in this advertising message fit in with its strategy for creating value? (Hint: Against
whom is Avis really competing for market share?)
Answer: Avis implanted in the consumer’s mind that if they didn’t rent from Hertz
they should rent from “Number Two” and forget about the others. Avis gave the
appearance of competing directly against Hertz. However, Avis’ real target was not
Hertz, but Budget Rent-a-Car, National and other rental cars who, at the beginning of
the campaign, approximated Avis’ market share.
CHAPTER 7: PROBLEMS
1. Suppose the United States imposes a $10 per barrel tariff on imported refined oil products.
a. What is the short-run profit outlook for American refineries? What is the long-term profit
outlook?
Answer: If a $10-a-barrel tax were levied on imported refined products, domestic

refined product prices would be elevated above the world level by $10 a barrel
compared with just $5 a barrel for crude oil. In such a case, distributors of refined
products would be forced to pay a price equal to the world price plus the tax for
their supplies. This would widen profit margins for U.S. refineries and shift the mix
of imports toward crude oil and away from refined products. Before-tax profit
margins for domestic oil refiners would rise by the amount of the tax.
Although tariffs would raise profits for the U.S. refining industry in the short run,
the industry’s long-run prognosis would be troublesome. The higher current profits
would draw more capital into the industry, capacity would expand, and prices and
profits would decline over time until once again the profitability of the refining
industry was no greater than that of any other industry.
b. Suppose that eight years after imposing this tariff, the United States revokes it. What is
likely to happen to the refining industry at that time?
Answer: If at a later date the U.S. government decided to eliminate the tariff, the
refining industry would be stuck with an enormous amount of excess capacity, prices
would fall, and many firms would go bankrupt as the industry downsized. This
actually describes what happened after the entitlement program, which was a
subsidy for refiners, was ended.
2. Wal-Mart, the discount merchandiser, began by putting large stores in small Sunbelt towns
that its competitors had neglected. The company then wrapped its stores in concentric rings
around regional distribution centers.
a. What was Wal-Mart’s original strategy for creating value?
Answer: The strategy requires domination of small markets, reinforced with
efficient distribution technologies.
b. How sustainable is the company’s competitive advantage?
Answer: The advantage is potentially sustainable. Competitors may find little
profit potential from tapping these limited markets. Even if they can, they would
have to create an equally efficient distribution system to compete with Wal-Mart.
c. How is growth in its markets likely to affect Wal-Mart’s strategy?
Answer: Growth may provide a greater incentive for competitive entry; rewards
increase while costs remain the same. Wal-Mart may be able to retain its
exclusionary access by expanding and cutting prices even further.
d. More recently, Wal-Mart has invested huge sums of money in a telecommunications
system that links its stores together and accumulates information instantaneously on store-
by-store sales of each item in stock . How might this investment create a competitive
advantage for Wal-Mart?
Answer: Wal-Mart may be able to retain its exclusionary access by expanding and
cutting prices even further.
3. Suppose General Motors’s worldwide profit breakdown is 85 percent in the United States, 3
percent in Japan, and 12 percent in the rest of the world. Its principal Japanese competitors
earn 40 percent of their profits in Japan, 25 percent in the United States, and 35 percent in the
rest of the world. Suppose further that through diligent attention to productivity and
substitution of enormous quantities of capital for labor (e.g., Project Saturn), GM manages to
get its automobile production costs down to the level of the Japanese.
a. Who is likely to have the global competitive advantage? Consider, for example, GM’s
ability to respond to a Japanese attempt to gain U.S. market share through a sharp price
cut.
Answer: Even if GM manages to get its costs down to the level of its Japanese
competitors, it will still face a competitive disadvantage because of asymmetrical
market shares. Suppose the Japanese cut their prices in order to gain market share
in the U.S. If GM responds with its own price cuts, it will lose profit on 85% of its
sales. By contrast, the Japanese will lose profit on only 25% of their sales. This puts
GM in a bind: If its responds to this competitive intrusion with a price cut of its
own, the response will hurt GM more than the Japanese.
b. What are the possible competitive responses of GM to the Japanese challenge?
Answer: GM could reduce its costs still further through some major technological
breakthroughs, by cutting domestic wages and benefits, or by sourcing more parts
and components abroad. It could also improve its product differentiation in ways
that are valued by auto buyers. Alternatively, GM could cut price in Japan.
c. How would you recommend that GM deal with the Japanese competition?
Answer: GM is actively engaged in various cost cutting activities and this activity
should continue regardless of what the Japanese do; it is not directly tied to their
behavior. The second response—better product differentiation—is problematic
given GM’s past history. The third alternative is the one to focus on. The correct
place for GM to retaliate against a Japanese competitive intrusion in the U.S. would
appear to be Japan, where their competitors earn 40% of their profits. This
response would hurt the Japanese more than it would hurt GM. But in order to
make this retaliatory threat credible, GM would have to build up its Japanese
market position, a tall order for any U.S. firm.
4. More and more Japanese companies are moving in on what once was an exclusive U.S.
preserve: making and selling the complex equipment that makes semiconductors. World sales
are between $3 billion and $5 billion annually. The U.S. equipment makers already have taken
a beating in Japan. Their share of the Japanese market, serviced by exports, has slumped to 30
percent in 1988 from a dominant 70 percent in the late 1970s. Because sales in Japan are
expanding as rapidly as 50 percent a year, Japanese concerns have barely begun attacking the
U.S. market. But U.S. experts consider it only a matter of time.
a. What are the possible competitive responses of U.S. firms?
Answer: The two classic responses are price cuts and innovation. Like GM’s
problem in the solution above, American firms may never be able to match the
Japanese cost advantage. The Wall Street Journal (01/09/85, p.34) reports that
“U.S. semiconductor manufacturers think they are better prepared than the
machine tool makers were. Several already are setting up manufacturing plants in
Japan to compete more effectively.” As in question 2, one should retaliate in the
competitor’s big market, not in one’s own market.
b. Which one(s) would you recommend to the head of a U.S. firm? Why?
Answer: The firm might be advised to match price on current production and
concentrate on the next wave in semiconductors. The firm should strive to
strategically build a competitive advantage in the revised technology and completely
overwhelm the market when the technology becomes current. It should concentrate
on a regular process of innovation and erection of barriers to entry, protecting
themselves against the incipient erosion of these barriers brought on by Japanese
competitors.
5. Airbus Industrie, the European consortium of aircraft manufacturers, buys jet engines from
U.S. companies. According to a recent story in the Wall Street Journal, “as a result of the
weaker dollar, the cost of a major component (jet engines) is declining for Boeing’s biggest
competitor.” The implication is that the lower price of engines for Airbus gives it a
competitive advantage over Boeing. Assess the validity of this statement. Will Airbus now be
more competitive relative to Boeing?
Answer: For US sales, assuming that all components are US, there will be no net effect.
The cost of supplies is lower for all inputs, but the price at which the products are sold
will reflect the deflated currency value as well. However, assuming that part of the
components or labor is European, Airbus will be at a relative disadvantage when it
discovers that it cannot earn as much (in the European currency equivalent) as it did
before. In general, the weaker dollar should make Boeing exports more lucrative.
6. Nordson Co. of Amherst, Ohio, a maker of painting and glue equipment, exports nearly half
its output. Customers value its reliability as a supplier. Because of an especially sharp run-up
in the value of the dollar against the French franc, Nordson is reconsidering its decision to
continue supplying the French market. What factors are relevant to reaching a decision?
Answer: The problem tells us that customers value Nordson’s reliability as a supplier.
If Nordson cuts and runs in France, other customers will take it as a signal as to how it
is likely to respond elsewhere when the going gets tough. This will hurt Nordson’s sales
to customers in other countries.
7. Tandem Computer, a U.S. maker of fault-tolerant computers, is thinking of shifting virtually
all the labor-intensive portion of its production to Mexico. What risks is Tandem likely to face
if it goes ahead with this move?
Answer: Tandem faces several risks:

a. Quality Control - Tandem may not be able to insure the same quality standards from
equipment produced at the Mexican plant.
b. Delivery Time - Tandem may not have access to an efficient delivery network because of
problems or misunderstandings concerning the Mexican transport systems.
c. Production Disruptions - Actions taken by labor or the Mexican government may affect
adversely factor costs or revenues from production.
d. Exchange Risk - Tandem runs the risk that the peso becomes expensive relative to the
dollar, or that Mexico experiences high inflation without devaluation of the peso.
8. Germany’s $28 billion electronics giant, Siemens AG, sells medical and telecommunications
equipment, power plants, automotive products, and computers. Siemens has been operating
in the United States since 1952, but its U.S. revenues account for only about 10% of
worldwide revenues. It intends to expand further in the U.S. market.
a. According to the head of its U.S. operation, “The United States is a real testing ground.
If you make it here, you establish your credentials for the rest of the world.” What does
this statement mean? How would you measure the benefits flowing from this rationale
for investing in the United States?
b. What other advantages might Siemens realize from a larger American presence?
9. Kao Corporation is a highly innovative and efficient Japanese company that has managed to
take on and beat Proctor & Gamble in Japan. Two of Kao’s revolutionary innovations include
disposable diapers with greatly enhanced absorption capabilities and concentrated laundry
detergent. However, Kao has had difficulty in establishing the kind of market-sensitive
foreign subsidiaries that P&G has built.
a. What competitive advantages might P&G derive from its global network of
market-sensitive subsidiaries?
b. What competitive disadvantages does Kao face if it is unable to replicate P&G’s global
network of subsidiaries?
10. Jim Toreson, chairman and CEO of Xebec Corporation, a Sunnyvale, California, manufacturer
of disk-drive controllers, is trying to decide whether to switch to offshore production. Given
Xebec’s well-developed engineering and marketing capabilities, Toreson could use offshore
manufacturing to ramp up production, taking full advantage of both low-wage labor and a
grab bag of tax holidays, low-interest loans, and other government largess. Most of his
competitors seemed to be doing it: The faster he followed suit, the better off Xebec would be,
according to the conventional discounted cash flow analysis, which showed that switching
production offshore was clearly a positive NPV investment. However, Toreson is concerned
that such a move would entail the loss of certain intangible strategic benefits associated with
domestic production.
a. What might be some strategic benefits of domestic manufacturing for Xebec? Consider the
fact that all its customers are American firms and that manufacturing technology—
particularly automation skills—is the key to survival in this business.
Answer: In the short run, these benefits include better quality control, better
communication with customers, and the ability to adapt quickly to changing
markets. In the long run, a domestic manufacturing facility would give Xebec a
laboratory in which to apply the latest thinking about automated production. By
working with the production process on a daily basis, Xebec would have a better
sense of the wider potential of the technology, of possible applications it might not
otherwise consider. For example, by running a highly-automated manufacturing
operation next door to the engineering group, Xebec could provide production-
related input in the early stages of product design, something that offshore
production managers can rarely do. With successfully automated production,
Xebec’s new disk drives could be offered with a price and quality level to match
those of potential competitors from Japan or anywhere else.

b. What analytic framework can be used to factor these intangible strategic benefits of
domestic manufacturing (which are intangible costs of offshore production) into the
factory location decision?
Answer: The intangible strategic benefits of domestic manufacturing can be
factored into the factory location decision by using a variant of the option-pricing
framework. By investing in domestic manufacturing Xebec creates for itself a series
of opportunities to invest capital in the future so as to increase the profitability of its
existing product lines and benefit from expanding into new products, markets or
new process technologies. Whether Xebec exercises these growth options depends
upon what happens in the future. The value of these growth options depend on
several factors:
1. The length of time the project can be deferred. Factory automation allows Xebec to
wait a longer time before responding to changes in the marketplace (because
automation permits it to respond so quickly once it decides to respond). The
investment in automation will also provide Xebec with a set of long-lasting skills.
2. The risk of the project. The riskier the investment the more valuable is an option on it.
Thus, an investment in automation is likely to be especially valuable since it so risky.
3. The level of interest rates. The higher the interest rate the more valuable are projects
that contain growth options.
4. The proprietary nature of the option. An exclusively owned option is clearly more
valuable than one that is shared with others.
Valuing an investment in automation that embodies discretionary follow-up projects
requires an expanded NPV rule that considers the attendant options. More specifically, the
value of the option equals the expanded NPV from investing in the project using discounted
cash flow analysis plus the value of the discretion associated with undertaking the project.
c. How would the possibility of radical shifts in manufacturing technology affect the
production location decision?
Answer: The possibility of radical shifts in manufacturing technology would
increase the benefits from investing in factory automation in the United States. The
phrase “radical shifts” implies that the project is high risk, which increases the
option component of value. For example, companies that in the mid-1970s made
the transition from electro-mechanical manually operated machine tools to
automatic, electronically controlled ones, were subsequently able to exploit the
revolution in capabilities—much higher performance at much lower cost—of the
microprocessors and microcontrollers that became available in the early 1980s. For
these companies, their operators, maintenance personnel, and process engineers
were already familiar and comfortable with electronic technology so that it was a
relatively simple task to retrofit powerful microelectronics when they became
available. Companies that had deferred investment in the emerging electronic
technology were not able to participate in the great technological advances in
microelectronics; they had not acquired an option in this new process technology.
d. Xebec is considering producing more sophisticated drives, which require substantial
customization. How does this possibility affect its production decision?
Answer: The more customization is required, the more important it is to work

closely with the customer. To meet the exacting needs of customers, there must be
close personal contact between Xebec’s engineering and production staff and
representatives of the purchasing company, something all but impossible to achieve
over 10,000 miles and with severe language and cultural barriers. It is also difficult
to coordinate the efforts of marketing, engineering, design and manufacturing
people when they are spread around the globe. This increases the value of domestic
production facilities.
e. An alternative sourcing option is to shut down all domestic production and contract to
have Xebec’s products built for it by a foreign supplier in a country like Japan. What might
be some potential advantages and disadvantages of foreign contracting vis-a-vis
manufacturing in a wholly owned foreign subsidiary?
Answer: The opposite of the answer for (a) is the potential for lower cost. However,
the time delay in transportation and innovation could cost Xebec both market share
and its technical edge.

Shapiro CapBgt IM

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Shapiro CapBgt IM

Hochgeladen von

Copyright:

Verfügbare Formate

Chapter 2: Capital-Budgeting Principles and Techniques

Chapter 2: Capital-Budgeting Principles and Techniques

Business Unit Return on Investment (%)

1. Whether these returns are representative of those expected to be earned in the

lead the return on investment to be overstated.

b. Should he put in the golf course?

NPV = ─36,000,000 + (1 ─ 0.40)(10,500,000)(4.6389) + (0.40)(4,500,000)(4.6389) =

Nicklaus should build the golf course (exactly as we expected).

a.b. * An alternate display is illustrative:

Housing With Golf

Project Investment Year 1 2 3 4 5

Project A Project B Project C

Acctg Rate of return (Average Net Income /Average Book Inv)

Projects B and C are acceptable based on a 20% accounting rate of return.

Answer: Assuming depreciation effects are included in the cash flows:

Assuming depreciation has not been included:

Answer: NPV = PV(After Tax Cash Flows) ─ Initial Investment

Answer: IRR is the discount rate that makes NPV = 0.

Depreciation not included:

e. Which projects should be chosen?

Answer. Here are the alternatives with their costs:

Answer: Plan S also has the higher NPV.

c. Which plan (S or L) should Fast Food choose? Why?

Answer: Under either criterion, Fast Food should choose Plan S.

b. Would your answer to (a) change if Roost used accelerated depreciation?

Answer: Accelerated depreciation results in the same numbers.

NPV = Equivalent Annual Benefit * PVIFA

Method A is consistent with Trump’s statement. Method B, however, is correct.

5. Flexible manufacturing systems enable companies to respond quickly to emerging market

be the only source of project gains.

Answer: The incremental cash flows can be found by calculating:

Incr Cash Flow = After Tax Savings + t * (Net Depreciation)

Answer: PVIFAr=10%,n=5 = 3.790787.

4. To capitalize on consumers’ concerns about healthful food, Specific Foods, Inc., is

Tax rate = 35% Total PV = $2120.065

Answer: Cost today = 1250 + 25 + 875(1 ─ 0.35) = $1843.750.

the project’s net present value under these assumptions?

Depreciation (old) 19,000 19,000 19,000

c. Which will the shareholders favor? The bondholders?

Answer: The possible oil price paths are diagramed below.

The results are summarized as follows:

0.216 0.80,─.26,─.10 0.44 ─0.0947

Low Mean High

(1) Sales (units) 160 500 960

E[NPV] = 2,000,000 + 6.447{ 500 (3750 3000) 200,000 }

Fixed cost $200,000 $600,000

Cash flows ($000) $50 $75 $130

NPV(000’s) = ─150 + 49.1/1.08 + 72.3 /1.082 + 123.11/1.083

Low Mean High

Tons per year 200,000 250,000 350,000

Cash flow: $100 P = .50 If cash flow in year 1 = $100

Variable (per year) Pessimistic Normal Optimistic

Current liabilities $2,000

Market Value Yield

Bonds (see market data) Bonds

4. A corporation’s securities have the following betas and market values:

Preferred discount rate rP = 10 + 0.4(5) = 12.0%

Answer: WACC = 0.105(0.25) + 0.12(0.50) + 0.175(0.25) = 13.0%

Movie House Beta D/TA*

NCO Theater, Inc. 1.70 .40

APV = $2.213M + 0.154M + 0.230M = $2.597M.

Westcon should undertake the project (APV>0).

APV = NPV of project if all-equity financed

Correlation of Rate of Return United States with