Week 3 Problem Set
Answer the following questions and solve the following
problems in the space provided. When you are done, save the file in the format
flastname_Week_3_Problem_Set.docx, where flastname is your first initial and
you last name, and submit it to the appropriate dropbox.
Chapter 7 (pages 225228):
Your brother wants to borrow $10,000 from you. He has
offered to pay you back $12,000 in a year. If the cost of capital of this
investment opportunity is 10%, what is its NPV? Should you undertake the
investment opportunity? Calculate the IRR and use it to determine the maximum
deviation allowable in the cost of capital estimate to leave the decision

You are considering an investment in a clothes distributor.
The company needs $100,000 today and expects to repay you $120,000 in a year
from now. What is the IRR of this investment opportunity? Given the riskiness
of the investment opportunity, your cost of capital is 20%. What does the IRR
rule say about whether you should invest?

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You are a real estate agent thinking of placing a sign
advertising your services at a local bus stop. The sign will cost $5,000 and
will be posted for one year. You expect that it will generate additional
revenue of $500 per month. What is the payback period?

You are deciding between two mutually exclusive investment
opportunities. Both require the same initial investment of $10 million.
Investment A will generate $2 million per year (starting at the end of the
first year) in perpetuity. Investment B will generate $1.5 million at the end
of the first year and its revenues will grow at 2% per year for every year
after that.

a. Which
investment has the higher IRR?
b. Which
investment has the higher NPV when the cost of capital is 7%?
c. In
this case, for what values of the cost of capital does picking the higher
IRR give the correct answer as to which investment is the best

Chapter 8 (260262)
Pisa Pizza, a seller of frozen pizza, is considering
introducing a healthier version of its pizza that will be low in cholesterol
and contain no trans fats. The firm expects that sales of the new pizza will be
$20 million per year. While many of these sales will be to new customers, Pisa
Pizza estimates that 40% will come from customers who switch to the new,
healthier pizza instead of buying the original version.
a. Assume customers will spend
the same amount on either version. What level of incremental sales is
associated with introducing the new pizza?
b. Suppose that 50% of the
customers who will switch from Pisa Pizzas original pizza to its healthier
pizza will switch to another brand if Pisa Pizza does not introduce a healthier
pizza. What level of incremental sales is associated with introducing the new
pizza in this case?

Cellular Access, Inc. is a cellular telephone service
provider that reported net income of $250 million for the most recent fiscal
year. The firm had depreciation expenses of $100 million, capital expenditures
of $200 million, and no interest expenses. Working capital increased by $10
million. Calculate the free cash flow for Cellular Access for the most recent
fiscal year.

A bicycle manufacturer currently produces 300,000 units a
year and expects output levels to remain steady in the future. It buys chains
from an outside supplier at a price of $2 a chain. The plant manager believes
that it would be cheaper to make these chains rather than buy them. Direct
in-house production costs are estimated to be only $1.50 per chain. The
necessary machinery would cost $250,000 and would be obsolete after 10 years.
This investment could be depreciated to zero for tax purposes using a 10-year
straight-line depreciation schedule. The plant manager estimates that the
operation would require $50,000 of inventory and other working capital upfront
(year 0), but argues that this sum can be ignored because
it is recoverable at the end of the 10 years. Expected proceeds from scrapping
the machinery after 10 years are $20,000.
If the company pays tax at a rate of 35% and the opportunity
cost of capital is 15%, what is the net present value of the decision to
produce the chains in-house instead of purchasing them from the supplier?


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