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):

1.

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

unchanged.

8.

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?

19.

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?

21.

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

opportunity?

Chapter 8 (260262)

1.

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?

6.

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.

12.

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?