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BUS 520 Managerial Finance 1. (14 points, 2 for part a, 3 for the others) AZM Corporation is deciding between the introduction of two new automobiles: a traditional gasoline-powered model, or a hydrogen fuel-cell model. Incremental cash flows in millions of dollars, to be received at the end of each period, are estimated to be: Year 0 1 2 3 4 5 Gas-Powered -540 320 240 160 40 0 Fuel Cell -650 40 80 160 300 600 (a) Compute each project’s payback period. (b) What is each project’s internal rate of return? (c) Compute each project’s net present value, assuming that the appropriate discount rate is 10% per year. (d) Assuming AZM’s goal is to maximize firm value, which project should be taken? Support your answer, including a short statement of which evaluation criterion was most relevant, which were less relevant, and why. (e) Compute each projects NPV again, assuming a discount rate of 14% per year. Does this change your recommendation? Explain the intuition. 2. (12 points) Carlson Corp. is considering whether to expand widget production. This would require the purchase of a new widget-producing machine at a cost of $5,400,000. The machine would produce 450,000 widgets per year during its useful life of three years, and would be depreciated for tax purposes at a rate of $1,800,000 per year. The machine would have a salvage value of $500,000. Expanding widget production would also require the use of a building that could otherwise be leased for $500,000 per year. Working capital would be 12% of the next year’s sales. Widget prices are $20 and are expected to remain stable. The materials and labor required to produce a widget cost $12, and these costs are also expected to remain stable. The income tax rate is 21%. The discount rate is 10% per year. (a) (9 pts) Compute the incremental free cash flow resulting from the purchase of a widget machine on a year-by-year basis. (b) (3 pts) What is the NPV of the widget machine? 3. (12 points – 9 for cash flow computations, 3 for NPV). Zither, Inc. has stumbled on a catchy new product. It recognizes that the product will be a fad, and as such will not continue to generate sales in the long run, but it wants your assessment of whether it should proceed anyway. Zither recently hired a consulting firm at a cost of $400,000. The consulting firm’s report indicates that Zither could anticipate selling 3,700, 4,000, 3,500, and 1,700 units over the upcoming four years, all at a premium price of $600 per unit. For simplicity assume that collections (as well as production costs and expenses) occur at the end of each year. It may also be relevant to note that Zither has many other product lines that generate millions of dollars per year in profits. The project would involve fixed production costs of $425,000 per year, as well as selling and administrative expenses equal to 13% of sales. In addition, Zither would have to invest $400,000 in working capital right away, though it would expect to recover the working capital at the end of the project. Production equipment would also have to be acquired right away, at a cost of $4.4 million. The equipment would be depreciated according to the 3-year MACRS schedule, and would have a salvage value of $800,000. Zither acquired land that would be suitable for the production facilities two years ago, at a price of $1 million. The current after-tax value of the land is $800,000, and Zither’s best estimate is that the land value will remain stable from here. Zither’s tax rate for ordinary income and capital gains is 21%, and it has determined that a 12% discount rate is appropriate. Compute the incremental cash flows that would result from a decision to proceed with the product, and the project’s NPV. 4. (12 points, 3 points for parts a and c, 2 points each other part) Surety Life Insurance Co. is just starting out, and so far has written only one policy. This policy will pay the company a premium of $2,500 next year, with certainty. However, there is a 0.2% chance that the insured will expire, and the company will have to pay a $1 million death benefit on the policy before the year is over. (a) List the probability distribution for Surety’s cash flow over the next year. (b) Compute Surety’s expected cash flow and standard deviation of cash flow over the next year. Assume now that Surety has written two smaller policies instead of the single policy described earlier. Each policy will pay Surety $1250 next year with certainty. The death benefit on each policy is $0.5 million. The probability of paying the death benefit is 0.2% for each policy, and the payouts on the two policies are statistically independent (implying that the correlation is zero). (Useful fact – the probability of a pair of independent events both occurring is the product of the individual probabilities.) (c) List the probability distribution for Surety’s cash flow over the next year. (d) Compute Surety’s expected cash flow and standard deviation of cash flow over the next year. (e) Explain the principle illustrated by comparing answers to parts (b) and (d).