Assignment

1. Recognizing risk Caradine Corp., a media services firm with net earnings of $3,200,000 in the last year, is considering the following projects.

The media services business is cyclical and highly competitive. The board of directors has asked you, as chief financial officer, to do the following:

• a.Evaluate the risk of each proposed project and rank it "low," "medium," or "high."
• b.Comment on why you chose each ranking.

2. Breakeven cash inflows and risk Blair Gasses and Chemicals is a supplier of highly purified gases to semiconductor manufacturers. A large chip producer has asked Blair to build a new gas production facility close to an existing semiconductor plant. Once the new gas plant is in place, Blair will be the exclusive supplier for that semiconductor fabrication plant for the subsequent 5 years. Blair is considering one of two plant designs. The first is Blair's "standard" plant, which will cost $30 million to build. The second is for a "custom" plant, which will cost $40 million to build. The custom plant will allow Blair to produce the highly specialized gases that are required for an emerging semiconductor manufacturing process. Blair estimates that its client will order $10 million of product per year if the traditional plant is constructed, but if the customized design is put in place, Blair expects to sell $15 million worth of product annually to its client. Blair has enough money to build either type of plant, and, in the absence of risk differences, accepts the project with the highest NPV. The cost of capital is 12%.

• a.Find the NPV for each project. Are the projects acceptable?

• b.Find the breakeven cash inflow for each project.

• c.The firm has estimated the probabilities of achieving various ranges of cash inflows for the two projects as shown in the following table. What is the probability that each project will achieve at least the breakeven cash inflow found in part b?

• d.Which project is more risky? Which project has the potentially higher NPV? Discuss the risk-return trade-offs of the two projects.

• e.If the firm wished to minimize losses (that is, NPV < $0), which project would you recommend? Which would you recommend if the goal were to achieve a higher NPV?

3. Impact of inflation on investments You are interested in an investment project that costs $40,000 initially. The investment has a 5-year horizon and promises future end-of-year cash inflows of $12,000, $12,500, $11,500, $9,000, and $8,500, respectively. Your current opportunity cost is 6.5% per year. However, the Fed has stated that inflation may rise by 1.5% or may fall by the same amount over the next 5 years.

Assume a direct positive impact of inflation on the prevailing rates (Fisher effect) and answer the following questions. (Assume that inflation has an impact on the opportunity cost, but that the cash flows are contractually fixed and are not affected by inflation).

• a.What is the net present value (NPV) of the investment under the current required rate of return?
• b.What is the net present value (NPV) of the investment under a period of rising inflation?
• c.What is the net present value (NPV) of the investment under a period of falling inflation?
• d.From your answers in a, b, and c, what relationship do you see emerge between changes in inflation and asset valuation?

4. Real options and the strategic NPV Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the firm's manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because

NPV_traditional = -$1,700 < $0

Before recommending rejection of the proposed project, she has decided to assess whether there might be real options embedded in the firm's cash flows. Her evaluation uncovered three options:

• Option 1: Abandonment. The project could be abandoned at the end of 3 years, resulting in an addition to NPV of $1,200.

• Option 2: Growth. If the projected outcomes occurred, an opportunity to expand the firm's product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add $3,000 to the project's NPV.

• Option 3: Timing. Certain phases of the proposed project could be delayed if market and competitive conditions caused the firm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of $10,000.

Jenny estimated that there was a 25% chance that the abandonment option would need to be exercised, a 30% chance that the growth option would be exercised, and only a 10% chance that the implementation of certain phases of the project would affect timing.

• a. Use the information provided to calculate the strategic NPV, NPVstrategic, for Asor Products' proposed equipment expenditure.

• b. Judging on the basis of your findings in part a, what action should Jenny recommend to management with regard to the proposed equipment expenditure?

• c.In general, how does this problem demonstrate the importance of considering real options when making capital budgeting decisions?

5. Capital rationing: NPV approach A firm with a 13% cost of capital must select the optimal group of projects from those shown in the following table, given its capital budget of $1 million.

• a. Calculate the present value of cash inflows associated with each project.
• b. Select the optimal group of projects, keeping in mind that unused funds are costly.