The following questions are conceptualquestions on several topics that we have discussed in the course.In answering the questions, be clear and to-the-point. Themotivation of your answer determines the grade.
- Suppose you have to choose between three projects. All involveproduction technologies that will be repeated at the end of theireconomic lives. Relevant project information is summarized below.Your supervisor expects a recommendation consistent withshareholder value maximization (his compensation package is linkedto the share price of the firm). Which of the projects would yourecommend to him, and how can you explain the difference in projectrankings between the different capital budgeting criteria? Motivateyour answer.
Project | T=0 | T=1 | T=2 | T=3 | IRR | NPV@10% | EA |
A | -$500,000 | $250,000 | $250,000 | $ 200,000 | 19.7% | $84,147 | $33,837 |
B | -$1,000,000 | $500,000 | $750,000 | - | 15.1% | $74,380 | $42,857 |
C | -$1,500,000 | $250.000 | $750,000 | $1,000,000 | 13.1% | $98,422 | $39,577 |
- As part of its efforts to stimulate the economy after thecrisis, the Obama administration allowed small businesses toimmediately write down capital expenditures for tax purposes. Thepolicy is now being reviewed as part of the discussion on corporatetax reform. One of your colleagues argues that this ultimate formof accelerated depreciation is always beneficial to companies.Another colleague argues that this is not necessarily true, butdepends on the salvage value of the asset at the time it is sold.In particular, if a firm sells an asset at a price above bookvalue, accelerated depreciation may be less attractive. A thirdcolleague points out that the depreciation method used by a firm isirrelevant, since depreciation is a non-cash expense, and thereforeonly affects accounting earnings. Please respond to each of thesestatements. Who do you agree with and how would you assess theattractiveness of the Obama policy? Motivate your answer.
- American Chemical, a large chemical conglomerate, is planningto buy the Paper division of Du Pont. A Stern student doing aninternship at the firm has been asked to identify the correct costof capital of American Chemical after the acquisition and collectedthe following firm and financial market information. The studentestablished that all firms in the table pay corporate taxes at a35% rate, and estimated a market risk premium of 6%. The targetcapital structure for the acquisition is 50% debt. AmericanChemical’s target capital structure has 40% debt and Du Pont’sPaper division has 30% debt. Describe clearly how the studentshould proceed in estimating the correct cost of capital. Motivateyour input choices, discuss any additional information you wouldneed and show the steps (You can include any formulas you woulduse)
