Evaluation of the treasurer's analysis:bWeighted average cost of capitalProportionWeighted costCost rateBondsStocksRetained earnings0%0.00%"Buffer" marginCutoff rate0.00%After-tax cash flows:Tax rate(1-tax rate)NOTE: enter adjusted amounts, expenses are negativeYear 3Year 1Year 2Year 4Year 5RevenueExpensesTaxes$ After tax cash flow (FVi/YPresent value calculations: Year (N)Present value (PV)FactorS25Total present valueSInvestment requiredNet present valueRecommendationc Sensitivity analysis:After tax cash flow (FVPresent value (PV)i/YPresent value calculations: Year (N)Revenue reductionRevised cash flowFactor25Total present valueInvestment requiredNet present valueRecommendationNOTE: Because the PV tables only include discount rates up to 12%, this requirement will require the use of a calculator or Excel fx.After tax cash flow (FVi/YPresent value (PV)Present value calculations: Year (N)Factor5Total present valueInvestment requiredSNet present valueRecommendation

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Asked Sep 17, 2019
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New Haven Corporation recently identified an investment opportunity invovling the purchase of a patent that will permit the company to modify its line of CD recorders.  The patent's purchase price is $720,000 and the legal protection it provides will last for five more years; there is no salvage value.  However, after preparing the capital expenditure analysis below, New Haven's treasurer has recommended to the company's captial budgeting committee that the investment be rejected.  Brad Decker, chairperson of the capital budgeting committee, find it diffult to accept the treasurer's analysis because he "feels intuitively" that the investment is attractive.  For this reason, he has retained you to review the treasurer's analysis and recommendation.  You are provided with the following data and summary of the treasurer's analysis:

1. Required investmnet: $720,000 cash for the patent to be amortized on a straight-line basis, five-year useful life, with zero salvage value.

2. Project cash revenue and operating expenses:

Year Cash Revenue Cash Expenses
1 $620,000 $240,000
2 560,000 200,000
3 400,000 170,000
4 250,000 80,000
5 200,000 50,000
  $2,030,000 $740,000

4. Income taxes: New Haven has an overall income tax rate of 30%.

5. Treasurers analysis:

Average cost of captial

(8% + 9% + 10%)/3 = 9%

   
Total cash revenue   $2,030,000
Total cash expenses $740,000  
Total amortization 720,000  
Total operating expenses   1,460,000
Projected net income over five years   570,000
Average annual income   114,000
Present value of future returns   443,420
Required investment   720,000
Negative net present value   (276,580)

Recommendation: Reject investment because of insufficient net present value.

Required:
a) Review the treasurer's anlysis, identifying any questionable aspects and beiefly comment on the apparent effect of each such item on the treasurer's analysis.

b) Prepare your own analysis of the investment, including a calculation of the proper cost of capital and hurdle rates, a net present value analysis of the project, and a brief recommendation to Decker regarding the investment (round amounts to nearest dollar).

c) Because of his concern for the uncertainties of the CD recorder business, Decker also has asked you to provied analyses supporting whether or not your recommendation would change

1. If estimates of projected cash revenue were reduced by 10%.

2. If the "buffer margin" were tripled from 2.5% to 7.5%

Refer to the two screenshots of the spreadsheets. below

Evaluation of the treasurer's analysis:
b
Weighted average cost of capital
Proportion
Weighted cost
Cost rate
Bonds
Stocks
Retained earnings
0%
0.00%
"Buffer" margin
Cutoff rate
0.00%
After-tax cash flows:
Tax rate
(1-tax rate)
NOTE: enter adjusted amounts, expenses are negative
Year 3
Year 1
Year 2
Year 4
Year 5
Revenue
Expenses
Taxes
$
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Evaluation of the treasurer's analysis: b Weighted average cost of capital Proportion Weighted cost Cost rate Bonds Stocks Retained earnings 0% 0.00% "Buffer" margin Cutoff rate 0.00% After-tax cash flows: Tax rate (1-tax rate) NOTE: enter adjusted amounts, expenses are negative Year 3 Year 1 Year 2 Year 4 Year 5 Revenue Expenses Taxes $

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After tax cash flow (FV
i/Y
Present value calculations: Year (N)
Present value (PV)
Factor
S
2
5
Total present value
S
Investment required
Net present value
Recommendation
c Sensitivity analysis:
After tax cash flow (FV
Present value (PV)
i/Y
Present value calculations: Year (N)
Revenue reduction
Revised cash flow
Factor
2
5
Total present value
Investment required
Net present value
Recommendation
NOTE: Because the PV tables only include discount rates up to 12%, this requirement will require the use of a calculator or Excel fx.
After tax cash flow (FV
i/Y
Present value (PV)
Present value calculations: Year (N)
Factor
5
Total present value
Investment required
S
Net present value
Recommendation
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After tax cash flow (FV i/Y Present value calculations: Year (N) Present value (PV) Factor S 2 5 Total present value S Investment required Net present value Recommendation c Sensitivity analysis: After tax cash flow (FV Present value (PV) i/Y Present value calculations: Year (N) Revenue reduction Revised cash flow Factor 2 5 Total present value Investment required Net present value Recommendation NOTE: Because the PV tables only include discount rates up to 12%, this requirement will require the use of a calculator or Excel fx. After tax cash flow (FV i/Y Present value (PV) Present value calculations: Year (N) Factor 5 Total present value Investment required S Net present value Recommendation

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Expert Answer

Step 1
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verage Colt of capital (WACC)represent, the minimum Tate that company Ahall pay to it security holders upresents the auerage castf rasing inance fram debt and eguty. I+ ia calculatad by adding cast of capital from debt and tax adjustments equ ty ajr maping certain Net pusent Value (NPV) is calculatdlto estimate the paitability of by deducting prsent Value of all puture inylo f Cash am the inhial cash ouflow particular praject. 1 is calulated a

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Part a) Given treasurer's analysis is not covrect vas aspects used in the calculation of aurage cost of Capital and NPV aru incovect. many Questionable aspects may include rates usud in the calculation of aurage cost of capital, No tax adjustment net prasent valut, Treawwr has addud dijerunt raty and divided the rult by 3.Cast of Capital of dierant ucurihie muthpied by (1-tax rat) to adjut the given tax ratı. so, Cost capital has been caluulatad eparately while caluulating NPV, Net cash Haw is calulated Jor éach amaunt tax has not while calculating et. . here cash oww in total Hdso has been calculated bien deductud ^rom the cah lows. So, thece is no tax adjustmen and amounh o Nev incasrrect

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Part-b) Given costs of Cafital for ditderertecuitiu in the treasurers analysis 8,9%% and 10% are Aerage Cort of capital ter tax adjustment wl be calulated as follouu 8(1-0.3) 90-0.3)+10 (1-0.3) 6.3 7 WACC= 1 5.6+ 18.9

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