5a) Developing Financial Insights

Questions

1) You just turned 35 and have been saving for an around-the-world vacation. You want to

take the trip to celebrate your 40th birthday. You have set aside, as of today, $15,000 for

such a trip. You expect the trip will cost $25,000. The financial instruments you have

invested $15,000 in have been earning, on average, about 8%. (You may ignore income

taxes.)

a) Will you have enough money in that vacation account on your 40th birthday to take

the trip? What will be the Surplus, or shortfall, in that account when you turn 40?

(Hint: Case Exhibit 1 will be useful in answering this question.)

b) If you had to, you could further fund the trip by making, starting today, five annual

$500 contributions to the account. If you adhere to such a plan, how much will be in

your account on your 40th birthday? (Hint: Case Exhibit 3 and the answer to part (a)

above, will both be useful in answering this question.) 2) Your company has been offered a contract for the development and delivery of a solarpowered military troop transport vehicle. The request for the proposal provides all the

necessary technical specifications and it also stipulates that two working, economically

feasible prototypes must be delivered in four years, at which time you will receive our

only customer payment – a single final payment of $50 million. Assume a reinvestment

interest rate of 18% for all the monies received over the next four years. (You may ignore

income taxes.)

a) What lump-sum dollar amount would you be willing to accept today instead of the

$50 million in four years? (Hint: Case Exibit 2 will be useful in answering this

question.)

b) Alternatively, what four year receipts, starting a year from now, might you be willing

to accept? (Hint: Case Exhibit 4 and the answer to part (a) above will both be useful

in answering this question.)

3) The aged but centrally located golf course you manage does not have an in-ground

automated water sprinkling system. Instead, to properly water the course, sprinklers and

hoses must be repeatedly set, moved, and put away by some of the grounds crew – a

tedious and laborious task. If over the next 12 years you project annual savings of about

$40,000 from having an automated system, what is the maximum price you would be

willing to pay today for an installed, automated golf course sprinkler system? (Assume

and interest rate of 6% and you may ignore income taxes.)

a) Redo your calculation using a 10-year time period and $48,000 in annual savings.

b) Redo you initial calculation one more time using $50,000 in annual savings for the

first six years and $30,000 in annual savings for the next six years.

4) The cafeteria you operate has a regular clientele for all three meals, seven days a week.

You want to expand your product line beyond what you are currently able to offer. To do

so requires the purchase of some additional specialty equipment costing $45,000, but you project a restaurant increase in sales (after deducting the cost of sales) of about $8,000

per year for each of the next eight years with this new equipment. Assuming a required

rate of return (i.e., a hurdle rate) of 8%, should you pursue this opportunity? Why or why

not? Do the analysis under two conditions:

a) You are part of an income-tax-exempt enterprise.

b) The enterprise you are part of is subject to a 40% corporate income tax rate and the

straight-line, depreciable life of the equipment you are contemplating purchasing is

five years.

5) You are contemplating the purchase of a one-half interest in a corporate airplane to

facilitate the expansion of your business into two new geographic areas. The acquisition

would eliminate about $220,000 in estimates annual expenditures for commercial flights,

mileage reimbursements rental cars, and hotels for each of the next 10 years. The total

purchase price for the ½ share is $6 million, plus associated annual operating costs of

$100,000. Assume the plane can be fully depreciated, on a straight line basis, for tax

purposes over 10 years. The company’s weighted average cost of capital (WACC) is 8%,

and its corporate tax rate is 40%. Does this endeavor present a positive or negative net

present value (NPV)? If positive, how much value is being created for the company

through the purchase of this asset? If negative, what additional annual cash flows are

needed for the NPV to equal zero? To what phenomena might those additional positive

cash flows be ascribable?

6) The final tally is in: This year’s operating cost were down $100,000, a decrease directly

attributable to the $520,000 investment in the automated materials handling system put in

place at the beginning of the year. If this level of annual savings continues for five more

years, resulting in six total years of annual savings, what compounded annual rate of return will that represent? If these annual savings continue for nine more years, what

compounded annual rate of return will that represent? (You may ignore income taxes.)

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