Reference no: EM133065550
Q1. Investment Project Choice. Toby Amberville's Manhattan Cafe, Inc., is considering investment in two alternative capital budgeting projects. Project A is an investment of $75000 to replace working but obsolete refrigeration equipment. Project B is an investment of $150000 to expand dining room facilities. Relevant cash flow data for the two projects over their expected 2-year lives are as follows:
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Project A
|
|
Year 1
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Year 2
|
|
Probability
|
Cash Flow ($)
|
Probability
|
Cash Flow ($)
|
|
0.18
|
0
|
0.08
|
0
|
|
0.64
|
50,000
|
0.84
|
50,000
|
|
0.18
|
100,000
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0.08
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100,000
|
|
Project B
|
|
Year 1
|
Year 2
|
|
Probability
|
Cash Flow ($)
|
Probability
|
Cash Flow ($)
|
|
0.50
|
0
|
0.125
|
0
|
|
0.50
|
200,000
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0.75
|
100,000
|
|
0.125
|
200,000
|
- Calculate the expected value, standard deviation, and coefficient of variation for cash flows from each project.
- Calculate the risk-adjusted NPV for each project using a 15 per cent cost of capital for the riskier project and a 12 per cent cost of capital for the less risky one. Which project is preferred using the NPV criterion?
- Calculate the PI for each project, and rank the projects according to the PI criterion.
- Calculate the IRR for each project, and rank the projects according to the IRR criterion.
- Compare your answers to parts B, C, and D, and discuss any differences.
Q2. Cash Flow Estimation.
Cunningham's Drug Store, a medium-size drugstore located in Milwaukee, Wisconsin, is owned and operatedby Richard Cunningham. Cunningham's sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Cunningham's most recent annual net income statement is as follows:
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Sales revenue
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$1,800,000
|
|
Total costs
|
|
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Cost of goods sold
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$1,260,000
|
|
Wages and salaries
|
200,000
|
|
Rent
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120,000
|
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Depreciation
|
60,000
|
|
Utilities
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40,000
|
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Miscellaneous
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30,000
|
|
Total Costs
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1,710,000
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Net profit before tax
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$90,000
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Cunningham's sales and expenses have remained relatively constant over the past few years and are expectedto continue unchanged in the near future. To increasesales, Cunningham is considering using some floor space for a small soda fountain. Cunningham would operatethe soda fountain for an initialthree-year period and then would reevaluate its profitability. The soda fountainwould require an incremental investmentof $20,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment requiredduring the three-year period.At the end of that time, additional capital would be requiredto continue operating the soda fountain, and no capitalwould be recovered if it were shut down. The soda fountainis expected to have annual sales of $100,000and food and materialsexpenses of $20,000 per year.The soda fountainis also expected to increase wage and salary expenses by 8% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of other fountain items are expectedto decline by 10%.
- Calculate net incremental cash flows for the soda fountain.
- Assume that Cunningham has the capital necessary to install the soda fountain and that he placesa 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not?
Q3. Cash Flow Analysis. Dunder-Mifflin, Inc., is analyzingthe potential profitability of three printingjobs put up for bid by the State Department of Revenue:
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|
Job A
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Job B
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Job C
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|
Projected winning bid (per unit)
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$5.00
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$8.00
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$7.50
|
|
Direct cost per unit
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$2.00
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$4.30
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$3.00
|
|
Annual unit sales volume
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800,000
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650,000
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450,000
|
|
Annual distribution costs
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$90,000
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$75,000
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$55,000
|
|
Investment required to produce annual volume
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$5,000,000
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$5,200,000
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$4,000,000
|
Assume that:
(1) the company's marginalcity-plus-state-plus-federal taxrate is 50%;
(2) each job is expected to have a six-year life;
(3) the firm uses straight-line depreciation;
(4) the average cost of capital is 14%;
(5) the jobs have the same risk as the firm's other business; and
(6) the company has already spent $60,000 on developing the precedingdata. This $60,000has been capitalized and will be amortized over the life of the project.
What is the expected net cash flow each year?(Hint: Cash flow equals net profit after taxesplus depreciation and amortization charges.)
What is the net present value of each project? On which project,if any, should the company bid?
Suppose that Dunder Mifflin's primary business is quite cyclical, improving and decliningwith the economy, but that job A is expected to be countercyclical. Might this have any bearing on your decision?
Q4. A manager must determine which of two products to market. From market studies, the manager constructed the following payoff matrix of the present value of all future net profits under all the different possible states of the economy:
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Product 1
|
|
State of the economy
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Probability
|
Profit ($)
|
|
Boom
|
0.2
|
50
|
|
Normal
|
0.5
|
20
|
|
Recession
|
0.3
|
0
|
|
Product 2
|
|
State of the economy
|
Probability
|
Profit ($)
|
|
Boom
|
0.2
|
30
|
|
Normal
|
0.4
|
20
|
|
Recession
|
0.4
|
10
|
The manager's utility function for money is
U = 100M - M2
where U is the total utility of money (in utils) and M refers to the dollars of profit.
- Determine if this manager a risk seeker, risk neutral, or a risk averter.
- If the manager's objective was profit maximization regardless of risk, which product should the manager introduces?
- Evaluate the risk associated per dollar of profit with each product.
- If the manager's objectives were utility maximization, which product should the manager introduce? (Hint: in this section, you can assume the same probability distribution indicated in the table above.)