Midterm 2 Part 2:

Problem 1: (10 Points)

 

Consider a factory that produces light bulbs.  The factory has an old piece of equipment, and the factory owner is considering replacing the old equipment with a new machine.  The owner is considering two options, with the following details:

 

Machine A Machine B
Cost to purchase the machine $50,000.00 $20,000.00
Variable cost per light bulb $0.18 $0.26
Fixed cost per year $100,000.00 $25,000.00
Life span (years) 10 10
Number of light bulbs factory will sell per year 600,000 500,000

 

  • The factory sells each light bulb for $0.40, the discount rate is 12%, and the corporate tax rate is 25%. The purchase of the machine occurs at year 0 and subsequent cash flows occur from years 1 through 10. Assume straight-line depreciation to zero for both machines. Assume no investment in net working capital. There is no salvage value.
  • The factory needs only one new machine. Which machine should the factory owner buy?

 

 

 

Problem 2: (20 Points)

 

Your company, Dawgs “R” Us, is evaluating a new project involving the purchase of a new oven to bake your hotdog buns. If purchased, the new oven will replace your existing oven, which was purchased seven years ago for a total installed price of $1 million.

 

You have been depreciating the old oven on a straight-line basis over its expected life of 15 years to an ending book value of $250,000, even though you expect it to be worthless at the end of that 15-year period. The new oven will cost $2 million and will fall into the MACRS five-year depreciation class life. If you purchase the new oven, you expect it to last for eight years. At the end of those eight years, you expect to be able to sell it for $100,000. (Note that both of the ovens, old and new, therefore have an effective remaining life of eight years at the time of your analysis.) If you do purchase the new oven, you estimate that you can sell the old one for its current book value at the same time.

 

The advantages of the new oven are twofold: Not only do you expect it to reduce the before-tax costs on your current baking operations by $75,000 per year, but you will also be able to produce new types of buns. The sales of the new buns are expected to bring your company $200,000 per year throughout the eight-year life of the new oven, while associated costs of the new buns are only expected to be $80,000 per year.

 

Since the new oven will allow you to sell these new products, you anticipate that NWC will have to increase immediately by $20,000 upon purchase of the new oven. It will then remain at that increased level throughout the life of the new oven to sustain the new, higher level of operations.

 

Your company uses a required rate of return of 12 percent for such projects, and your incremental tax rate is 34 percent. What will be the total cash flows for this project?

 

Using project cash flows; solve for NPV, IRR, Payback period, Discounted payback period and Profitability Index of the project and define the investment decision as accept or reject for each method. (Assume your benchmark for payback and discounted payback period methods as 5 years or less)

 

 

Note: MACRS 5 yr is as follows; 20%, 32%, 19.20%, 11.52%, 11.52%, 5.76%

 

 

 

 

 

 

Problem 3: (20 Points)

 

Download daily prices for Apple Inc (AAPL) and Simon Property Group (SPG) from the last two years. (Between 11/15/2018 and 11/15/2020) (You may get the data from finance.yahoo.com or other sources online and use adjusted close prices)

In an Excel spreadsheet;

 

  1. Calculate daily percentage returns for both stocks and then calculate their average return, variance, standard deviation of returns.
  2. Calculate covariance and correlation of APPL and SPG
  3. Consider you have a portfolio consists of 200 shares of Apple (Share price is $118) and 500 shares of SPG (Share price is $80). Calculate portfolio expected return, variance, and standard deviation
  4. APPL beta is 1.35 and SPG beta is 1.34. Calculate expected return of each stock with a risk free rate of 1% and expected market return of 3%.

 

Problem 4: (10 Points)

 

Consider the following two bonds:

Bond A

Term to maturity: 10 years from today

Face value: $1,000

Annual Coupon rate: 6%

Number of payments per year: 2

Bond B

Term to maturity: 20 years from today

Face value: $1,000

Annual Coupon rate: 9%

Number of payments per year: 2

  • Compute the price for each bond. The current YTM for each bond is 8%. Then make a table comparing the bond prices when the YTM varies from 1%, 2% … 17%.