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Long-Term Investments

1. ; A firm has the opportunity to invest in a project having an initial outlay of $20,000. ; Net cash inflows (before depreciation and taxes) are expected to be $5,000 per year for five years. ; The firm uses the straight-line depreciation method with a zero salvage value and has a (marginal) income tax rate of 40 percent. ; The firm’s cost of capital is 12 percent.

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a. ; Compute the internal rate of return and the net present value.

b. ; Should the firm accept or reject the project?

5. ; The Charlotte Bobcats, a professional basketball team, has been offered the opportunity to purchase the contract of an aging superstar basketball player from another team. ; The general manager of the Bobcats wants to analyze the offer as a capital budgeting problem. ; The ; Bobcats would have to pay the other team $800,000 to obtain the superstar. ; Being somewhat old, the basketball player is expected to be able to play for only four more years. ; The general manager figures that attendance, and hence the revenues, would increase substantially if the Bobcats obtained the superstar. ; He estimates that incremental returns (additional ticket revenues less the superstar’s salary) would be as follows over the four-year period:

; YEAR ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ;INCREMENTAL RETURNS

1 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ;$450,000

2 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; 350,000

3 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; 275,000

4 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; 200,000

The general manager has been told be the owners of the team that any capital expenditures must yield at least 12 percent after taxes. ; The firm’s (marginal) income tax rate is 40 percent. ; Furthermore, a check of the tax regulations indicates that the team can depreciate the $800,000 intial expenditure over the four-year period.

a. ; Calculate the internal rate of return and the net present value to determine the desirability of this investment.

b. ; Should the Bobcats sign the superstar?

9. ; 9. ; The state of Glottamora has $100 million remaining in its budget for the current year. ; One alternative is to give Glottamorans a one-time tax rebate. ; Alternatively, two proposals have been made for state expenditures of these funds. ; The first proposed project it to invest in a new power plant, costing $100 million and having an expected useful life of 20 years. ; Projected benefits accruing from this project are as follows:

YEARS ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; BENEFITS PER YEAR (MILLIONS)

1-5 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; $0

6-20 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ;20

The second alternative is to undertake a job retraining program, also costing $100 million and generating the following benefits:

YEARS ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; BENEFITS PER YEAR (MILLIONS)

1-5 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; $20

6-10 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; 14

11-20 ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; ; 4

The state Power Department argues that a 5 percent discount factor should be used in evaluating the projects, because that is the government’s borrowing rate. ; The Human Resources Department suggests using a 12 percent rate, because that more nearly equals society’s true opportunity rate.

c. ; What rate do you believe to be more appropriate?

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