1. Assume that you are analyzing a proposed asset acquisition where the assets will cost $5 million, plus $200,000 to have them delivered and installed. The project will result in sales of 6000 units in the first year of operations. The sales price will be $190 per unit and the operating costs (excluding depreciation) will be $140 per unit. The assets will be depreciated using the MACRS 5-year rates. The project will require a level of net working capital of 5% of the following year's sales. The number of units sold is expected to increase by 20% per year in the second year of the project. Growth is estimated to be 15% in the third year, and 0 in the fourth year. The sales price and operating costs per unit are expected to remain the same for the length of the project. The assets will have a salvage value of $450,000 at the end of four years. Calculate the Initial Investment Outlay for the project, and the Net Operating Cash Flows for the four years of this project and the terminal cash flow. Assume a tax rate of 40%. If the appropriate cost of capital is 8%, calculate the Profitability Index, Internal Rate of Return, and Payback Period for this project. Should it be accepted? Why or why not?
2. Explain what "real options" are in the context of capital budgeting. Provide two specific examples of real options. In general, what effect do real options have on most projects, and how can we measure the effect?
3. You have an old computer system with a book value of $120,000. It could be sold today for $150,000. A new, more powerful and efficient system could be purchased today for $600,000. It would save the firm an estimated $120,000 per year in reduced labor, but would have no effect on sales. The old computer had two more years of depreciation left in the amount of $60,000 per year. The new computer will be depreciated at the rate of 20% in the first year. What are the initial cash flow at time 0 and the cash flow for year 1 for this replacement analysis. Do not worry about the remaining years' cash flows.
4. What is the problem that can occur when using multiple time-value-of-money techniques to evaluate sets of mutually exclusive projects? What is the best way to resolve this problem? Please be specific and complete.