eco 550 check your understanding week 10

Chapter 17: Problems 1, 5, and 9(c)

Week 10 – Check Your Understanding

Chapter 17 Exercise 1, 5, and 9(c)

A firm has the opportunity to invest in a project having an initial outlay of \$20,000.  Net cash inflows (before depreciation and taxes) are expected to be \$5,000 per year for five years.  The firm uses the straight-line depreciation method with a zero salvage value and has a (marginal) income tax rate of 40 percent.  The firm’s cost of capital is 12 percent.

a)      Compute the internal rate of return and the net percent value.

b)      Should the firm accept or reject the project?

5. The Charlotte Bobcats, a professional basketball team, has been offered the opportunity to purchase the contract of an aging superstar basketball player from another team.  The general manager of the Bobcats wants to analyze the offer as a capital budgeting problem.  The Bobcats would have to pay the other team \$800,000 to obtain the superstar. Being somewhat old, the basketball player is expected to be able to play for only four more years.  The general manager figures that attendance, and hence revenues, would increase substantially if the Bobcats obtained the superstar.  He estimates that incremental returns (additional ticket revenues less the superstar’s salary) would be as follows over the four-year period:

YEAR

INCREMENTAL RETURNS

1

\$450,000

2

350,000

3

275,000

4

200,000

The general manager has been told by the owners of the team that any capital expenditures must yield at least 12 percent after taxes. The firm’s (marginal) income tax rate is 40 percent. Furthermore, a check of the tax regulations indicates that the team can depreciate the \$800,000 initial expenditure over the four-year period.

a)      Calculate the internal rate of return and the net present value to determine the desirability of this investment.

b)      Should the Bobcats sign the superstar?

9. The state of Glottamora has \$100 million remaining in its budget for the current year. One alternative is to give Glottamorans a one-time tax rebate. Alternatively, two proposals have been made for state expenditures of these funds.

The first proposed project is to invest in a new power plant, costing \$100 million and having an expected useful life of 20 years.  Projected benefits accruing from this project are as follows:

YEARS

BENEFITS PER YEAR (\$ MILLIONS)

1-5

\$0

6-20

20

The second alternative is to undertake a job retraining program, also costing \$100 million and generating the following benefits:

YEARS

BENEFITS PER YEAR (\$ MILLIONS)

1-5

\$20

6-10

14

11-20

4

The state Power Department argues that a 5 percent discount factor should be used in evaluating the projects, because that is the government’s borrowing rate.  The Human Resources Department suggests using a 12 percent rate, because that more nearly equals society’s true opportunity rate.

c. What rate do you believe to be more appropriate?

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