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Problem 6

Topic from Chapter 7. Assume that a project has an initial investment of 60M and then Project FCF in subsequent years of 10,20 and 50M.

a. Assume the firm has a WACC of 7.5%. Should they take this project? Why? What if the manager of the project was worried that he has to authorize $60M in year 0, but only earns $10M in year 1 and $20M in year 2 so he's still "in the hole" until year 3. Is that a relevant concern? (2 points)

b. Use EVA to adjust the cash flows of this project in years 1-3 to calculate the Economic Profit in each year. Assume that there are no additional investments in CAPEX or working capital in years 1,2 and 3. Also assume that the 60M is depreciated at 20M/ year (3 year life, straight line). This means the invested capital decreases 20M / year as well. Think about the relationship between NOPAT and PFCF. What is the MVA of the project? Should you invest in it? Does compensating the manager for positive economic profit in each year help entice her to take the project? (3 points)

c. Use the concept of economic depreciation to adjust the cash flows in years 1-3. What is the MVA of the project now? Does compensating the manager for positive adjusted economic profit in each year help entice her to take the project? (3 points)

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