1. Esteez Construction Company has an overhead crane that has an estimated remaining life of 7 years. The crane can be sold for $14000. If the crane is kept in service it must be overhauled immediately at a cost of $6000. Operating and maintenance costs will be $5000/year after the crane is overhauled. After overhauling it, the crane will have a zero salvage value at the end of the 7-year period. A new crane will cost $36000 and will last for 7 years with a $8000 salvage value at the end of that time. Operating and maintenance costs are $2500 for the new crane. Esteez uses an interest rate of 15% in evaluating investment alternatives. Should the company buy the new crane based upon annual cost analysis? Please use the Cash-flow Approach.
2. A publishing company has carried out a market survey estimating future demand for a new book and have produced the following probability estimates:
Year 1 Year 2 Year 3
Likely sales Probability Likely sales Probability Likely sales Probability
5,000 0.2 5,000 0.4 5,000 0.8
10,000 0.5 10,000 0.6 10,000 0.2
20,000 0.3
(a) Calculate the expected total sales (i.e., number of books) over the three years
(b) The book's price is fixed at $10 and the variable cost of producing each book will be $2 in year 1, $3 in year 2 and $4 in year 3. Calculate the present value of this project, using a discount rate of 10 per cent per annum. Assume that all cash flows take place at the end of the year concerned.
(c) There is a possibility of an updated soft back version of the book being published at the beginning of year 2 (the original hard-backed version would then be taken off the market at the end of year 1) with the following estimates of sales:
Year 2 Year 3 Year 4
Likely sales Probability Likely sales Probability Likely sales Probability
20,000 0.5 10,000 0.8 5,000 0.9
30,000 0.5 20,000 0.2 10,000 0.1
(The sales will be extended by one year due to the updating)
The soft-backed book will be priced at $5 and the variable cost of producing each book will be $1 in year 2, $2 in year 3, and $3 in year 4. Should the option to produce the soft-backed edition be taken up?
3. A company has already spent $80,000 developing a new product, and is now considering whether or not to market the product. Tooling for production of the new product would cost $50,000. If the product is produced and marketed, the company estimates that there is only one chance in four that the product would be successful. If successful, the net income would be $100,000 per year for 8 years. If not successful, the company would loose $30,000 per year for 2 years, after which time the venture would be terminated. The minimum rate of return on money is 20% per year.
a. Draw a decision tree and determine the best alternative using the expected net present value criterion.
b. There is a market research group that can provide perfect information about the success or otherwise of the product at a cost of $20,000. Should the company engage the market research group?
Note: In your calculations for part (b) of the question, use the same probabilities for the outcomes of the market research as indicated above, i.e. one in four for success.