160. HHR Construction, Inc. is currently considering developing, on a piece of land currently
held by the company, a new courtyard motel. This project would provide a single payoff from a
buyer in one year (after construction was completed). The concept of a courtyard motel is
relatively new, so there is a certain amount of risk associated with this project. The company’s
management feels that in approximately a year from now new information regarding potential
consumer demand would be revealed, that is, whether in the chosen geographic location a
courtyard motel would be popular (“good news”) or unpopular (“bad news”). In the former case,
you anticipate a selling price of $13 million, while in the latter case only $9 million. At the
present, these two outcomes are considered equally likely. For projects of this sort, the company
uses a WACC (discount rate) of 10% after tax. The company estimates that total construction
costs for this project would, in today’s dollars, be approximately $9.7 million.
Required:
1. Based on the given probabilities for the two possible outcomes (states of nature), what is the
expected
NPV of the proposed investment? (At 10%, PV factor for one year = 0.909.)
2. What is the primary deficiency of the traditional DCF analysis you conducted above in
Requirement (1)?
3. Suppose now that management has an option to wait a year before deciding whether to
construct the motel in question. The question the company is grappling with is whether it should
delay the investment decision for one year. Given the information above, what do you
recommend, and why? (For simplicity, assume that one year from now the investment cost would
be $9.7 million and that the return one year later would be $13 million.)
4. Define the term “real option.” Compare real options with financial options.
5. This problem deals with what is called an investment-timing option, one of four general
classes of real options. What other types of real options can be embedded in a capital investment
proposal? How do these classes relate to
put options
and
call options
?
161. Omaha Plating Corporation is considering purchasing a machine for $1,500,000. The
machine will generate a constant after-tax income of $100,000 per year for 15 years. The firm will
use straight-line (SL) depreciation for the new machine over 10 years with no residual value. Its
estimated weighted-average cost of capital (WACC) for evaluating capital expenditure proposals
is 10%. Note: the PV $1 factor for 10 years, 10% is 0.386; the PV annuity factor for 10%, 10 years
is 6.145; and, the PV annuity factor for 10%, 5 years is 3.791.
Required:
Using a discount rate of 10%, what is the estimated net present value (NPV) of the proposed
investment (rounded to the nearest thousand)?
162. Marc Corporation wants to purchase a new machine for $400,000. Management predicts
that the machine can produce sales of $275,000 each year for 5 years. Expenses are expected to
include direct materials, direct labor, and factory overhead (
excluding depreciation
) totaling
$80,000 per year. The company uses MACRS for depreciation. The machine is considered as a 3–
year property and is not expected to have any significant residual value at the end of its useful
life. The company is subject to a 40% income tax rate. Management uses a 10% weighted–
average cost of capital (WACC) to evaluate proposed capital expenditures. A partial MACRS
depreciation table is reproduced below.
Year 3-year property 5-year property
1 33.33 20.00
2 44.45 32.00
3 14.81 19.20
4 7.41 11.52
5 11.52
6 5.76
Required:
1. What is the payback period for the new machine (rounded to the nearest tenth of a year)?
Assume for purposes of this calculation that the cash inflows occur evenly throughout the year.
2. What is the accounting (book) rate of return (ARR) (rounded to two decimal points) based on
the initial investment and on average after-tax income over the five-year period?
3. What is the accounting (book) rate of return (ARR) (rounded to two decimal points), based on
the average investment, where the latter is determined as a simple average of beginning–of–
project and end–of-project book value of the asset?
163. Marc Corporation wants to purchase a new machine for $400,000. Management predicts
that the machine can produce sales of $275,000 each year for next 5 years. Expenses are
expected to include direct materials, direct labor, and factory overhead (
excluding depreciation
)
totaling $80,000 per year. The company uses MACRS (modified accelerated cost recovery
system) for depreciation. The machine is considered as a 3-year property and is not expected to
have any significant residual at the end of its useful years. Marc’s income tax rate is 40%.
Management estimates that the weighted-average cost of capital (WACC) is 10%. A partial
MACRS depreciation table is reproduced below.
Year 3-year property 5-year property
1 33.33 20.00
2 44.45 32.00
3 14.81 19.20
4 7.41 11.52
5 11.52
6 5.76
Required:
1. What is the estimated net present value (NPV) of the investment (rounded to the nearest
whole dollar)? (Note: PV $1 factors for 10% are as follows: year 1 = 0.909; year 2 = 0.826; year 3
= 0.751; year 4 = 0.683; year 5 = 0.621; the PV annuity factor for 10%, 5 years = 3.791.) Assume
that all estimated cash flows occur at year-end.
2. What is the present value payback period (rounded to two decimal points)?
