Activity 1. Memo from Bob:

I need to help our client, Rondo, make a decision on whether or not to go ahead with a project. I?d like you to do a net present value (NPV) analysis on this special production project. The project will require an initial investment in a piece of manufacturing equipment. The product will be sold exclusively to the client over the next three years.

Please prepare an NPV analysis of the Rondo project. I have compiled the following cost and sales estimates from engineering and marketing.

1. Project life is 3 years.

2. Initial investment is $7,550,000 for equipment invoice, transportation, and installation.

3. Worker training for operating new equipment is $18,000.

4. First-year sales are projected to be $4,500,000 escalated at 3.5% each year thereafter.

5. Operating overhead (excluding depreciation) is estimated at 27% of annual sales.

6. Administrative overhead is estimated at 35% of annual sales.

7. Depreciation is straight line, 5 years.

8. The tax rate is 40%.

9. The new equipment can be salvaged at the end of the project (end of YR 3) for $2,500,000.

10. Cost of capital is 10%.

You?ll need to create an Excel cash flow spreadsheet and calculate the NPV and IRR. Make your recommendation on the project.

A few observations:

1. Please do not forget how to treat the depreciation: first as an item for the net income and then to add it back for the cash flows; and it is straight line depreciation.

2. Worker training to be expensed in period 0. But keep in mind that you would want to view it on an after tax basis.

3. Please do not forget the terminal cash flow which depends on the salvage value and the remaining book value of the asset!

Activity2: Calculation of the Outcomes of the Calls and Puts Held Long and Short

Bob needs your opinion. You receive a voice mail.

In order to make the decision on the best course of action, two tables of calculations are needed:

1. One table for calculations on:

a. The possible outcomes of buying a call option for $2.10, exercise price $37.50

b. Possible price ranges for the underlying stock: 25 30 35 40 45 50 55 60

2. A second table for calculations on:

a. The possible outcomes of buying a put option for $1.65, exercise price $37.50

b. Possible price ranges for the underlying stock: 25 30 35 40 45 50 55 60

Deliverables

1. A worksheet showing your calculations of the outcomes for the suggested stock price ranges for the call option buying strategy;

2. A worksheet showing your calculations of the outcomes for the suggested stock price ranges for the put option buying strategy.

Activity 1. Memo from Bob: I need to help our client, Rondo, make a decision on whether or not to go ahead with a project. I'd like you to do a net present value (NPV) analysis on this special production project. The project will require an initial investment in a piece of manufacturing equipment. The product will be sold exclusively to the client over the next three years. Please prepare an NPV analysis of the Rondo project. I have compiled the following cost and sales estimates from engineering and marketing. 1. Project life is 3 years. 2. Initial investment is $7,550,000 for equipment invoice, transportation, and installation. 3. Worker training for operating new equipment is $18,000. 4. First-year sales are projected to be $4,500,000 escalated at 3.5% each year thereafter. 5. Operating overhead (excluding depreciation) is estimated at 27% of annual sales. 6. Administrative overhead is estimated at 35% of annual sales. 7. Depreciation is straight line, 5 years. 8. The tax rate is 40%. 9. The new equipment can be salvaged at the end of the project (end of YR 3) for $2,500,000. 10. Cost of capital is 10%. You'll need to create an Excel cash flow spreadsheet and calculate the NPV and IRR. Make your recommendation on the project. A few observations: 1. Please do not forget how to treat the depreciation: first as an item for the net income and then to add it back for the cash flows; and it is straight line depreciation. 2. Worker training to be expensed in period 0. But keep in mind that you would want to view it on an after tax basis. 3. Please do not forget the terminal cash flow which depends on the salvage value and the remaining book value of the asset! Activity2: Calculation of the Outcomes of the Calls and Puts Held Long and Short Bob needs your opinion. You receive a voice mail. In order to make the decision on the best course of action, two tables of calculations are needed: 1. One table for calculations on: a. The possible outcomes of buying a call option for $2.10, exercise price $37.50 b. Possible price ranges for the underlying stock: 25 30 35 40 45 50 55 60 2. A second table for calculations on: a. The possible outcomes of buying a put option for $1.65, exercise price $37.50 b. Possible price ranges for the underlying stock: 25 30 35 40 45 50 55 60 Deliverables 1. A worksheet showing your calculations of the outcomes for the suggested stock price ranges for the call option buying strategy; 2. A worksheet showing your calculations of the outcomes for the suggested stock price ranges for the put option buying strategy. SN A B C D E F G H I J K L M N O P Q Year Initial Investment Worker Training Post-Tax Worker Training (B - 40%) Sales Sales Growth Operating Overhead (27% of Sales in Row D) Adminitrative Overhead (35% of Sales in Row D) Depreciation (A / 5) Profit Before Tax (D + F + G + H) Tax Expense (40% of PBT in Row I) Profit After Tax (I + J) Add: Depreciation (H) WDV of Initial Investment (A - sum of Depreciation in 3 years) Salavge Value of Initial Investment Capital Loss on excess of WDV over Salvage value (M - N) Tax Saving on Capital Loss @ 40% (40% * O) Terminal Cash Flow (N + O) 0 ($7,550,000) ($18,000) ($10,800) R S T Net Free Cash Flow (A + C + K + L + Q) Discounting Factor @ 10% Present Value of Free Cash Flow (R * S) 1 $4,500,000 $0 $0 $0 $0 ($1,215,000) ($1,575,000) ($1,510,000) $200,000 ($80,000) $120,000 $1,510,000 $0 $0 ($7,560,800) 1.00000 ($7,560,800) $1,630,000 0.90909 $1,481,818 2 3 $4,702,500 $4,914,113 4.50% 4.50% ($1,269,675) ($1,326,810) ($1,645,875) ($1,719,939) ($1,510,000) ($1,510,000) $276,950 $357,363 ($110,780) ($142,945) $166,170 $214,418 $1,510,000 $1,510,000 $3,020,000 $2,500,000 $520,000 $208,000 $0 $2,708,000 $1,676,170 0.82645 $1,385,264 $4,432,418 0.75131 $3,330,141 U NPV (Sum of T) ($1,363,576) V IRR 0.99% Analysis: Since IRR at 0.99% is lower than the cost of capital of 10%, the NPV is negative and hence client Rondo should not go ahea with the project. Buying a call option Spot Price Strike Price Premium Premium outflow $25 $37.50 $2.10 ($2.10) $30 $37.50 $2.10 ($2.10) $35 $37.50 $2.10 ($2.10) $40 $37.50 $2.10 ($2.10) $45 $37.50 $2.10 ($2.10) $50 $37.50 $2.10 ($2.10) $55 $37.50 $2.10 ($2.10) $60 $37.50 $2.10 ($2.10) Payoff Inflow on maturity Net Profit / (Loss) $0.00 ($2.10) $0.00 ($2.10) $0.00 ($2.10) $2.50 $0.40 $7.50 $5.40 $12.50 $10.40 $17.50 $15.40 $22.50 $20.40 Buying a Put option Spot Price Strike Price Premium Premium outflow $25 $37.50 $1.65 ($1.65) $30 $37.50 $1.65 ($1.65) $35 $37.50 $1.65 ($1.65) $40 $37.50 $1.65 ($1.65) $45 $37.50 $1.65 ($1.65) $50 $37.50 $1.65 ($1.65) $55 $37.50 $1.65 ($1.65) $60 $37.50 $1.65 ($1.65) Payoff Inflow on maturity Net Profit / (Loss) $12.50 $10.85 $7.50 $5.85 $2.50 $0.85 $0.00 ($1.65) $0.00 ($1.65) $0.00 ($1.65) $0.00 ($1.65) $0.00 ($1.65) C olumn F C olumn F