Question 2 (a) The manufacturing firm Rebo is considering a new capital investment project. The project will last for five years. The anticipated sales revenue from the project is $3 million in year 1 and $4.2 million in each of years 2 – 5. The cost of materials and labour is 50% of sales revenue and other expenses are $1 million in each year. The project will require working capital investment equal to 20% of the expected sales revenue for each year. This investment must be in place at the start of each year. Working capital will be recovered at the end of the project’s life. The project will require $2.5 million to be spent now on new machinery which will have zero value at the end of the project and will be depreciated each year at 20% of the original cost. The tax rate is 25%. Rebo uses a discount rate of 11% to evaluate its capital investment projects. i. What is the net income in each year? ii. What is the free cash flow in each year and the net present value (NPV)? iii. You discover the following additional information: • The project will utilise a building that the firm leases. No other activities take place in it. If this project does not go ahead the firm will terminate the lease in one year’s time if no other use for it has been found. • Part of each year’s cash flows from the project will be used to increase the dividend payment to shareholders. 5FN2191 Principles of corporate finance For each of these items, explain briefly whether or not you would incorporate the information into your analysis of the project’s value.
Question 2
(a) The manufacturing firm Rebo is considering a new capital investment project.
The project will last for five years. The anticipated sales revenue from the
project is $3 million in year 1 and $4.2 million in each of years 2 – 5. The cost of materials and labour is 50% of sales revenue and other expenses are $1 million in each year. The project will require working capital investment equal to 20% of the expected sales revenue for each year. This investment must be in place at the start of each year. Working capital will be recovered at the end of the project’s life.
The project will require $2.5 million to be spent now on new machinery which will have zero value at the end of the project and will be
i. What is the net income in each year?
ii. What is the
iii. You discover the following additional information:
• The project will utilise a building that the firm leases. No other activities
take place in it. If this project does not go ahead the firm will terminate
the lease in one year’s time if no other use for it has been found.
• Part of each year’s cash flows from the project will be used to increase the
dividend payment to shareholders.
5FN2191 Principles of
For each of these items, explain briefly whether or not you would incorporate
the information into your analysis of the project’s value.
(b) Zuti has a capital investment project that could start immediately. The project
will require a machine costing $2.4 million. The total discounted value now of
the
equal probability. The risk-free rate is 3%.
Instead of starting immediately the project could be delayed until one year from
now to gain more market information. Its total discounted cash inflows at that
time will be known as either $2.6 million, or $1.9 million, with certainty.
i. What is the present value of the option to delay?
ii. The supplier of the machine has offered to deliver it (if required) in one
year’s time at a price of only $2 million, if Zuti pays a non-refundable deposit
now. What is the maximum the firm should pay as a deposit now? What
type of real option does this represent for Zuti? Identify the specific
components of the option contract.
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