Business Case

Maximilian Bohm is reviewing several capital budgeting proposals from subsidiaries of his company. Although his reviews deal with several details that may seem like minutiae, the company places a premium on the care it exercises in making its investment decisions.

Maximilian Bohm is reviewing several capital budgeting proposals from subsidiaries of his company. Although his reviews deal with several details that may seem like minutiae, the company places a premium on the care it exercises in making its investment decisions.

Another proposal concerns Gasup Company, which does natural gas exploration. A new investment has been identified by the Gasup finance department with the following projected cash flows:

• Investment outlays are $6 million immediately and $1 million at the end of the first year.
• After-tax operating cash flows are $0.5 million at the end of the first year and $4 million at the end of each of the second, third, fourth, and fifth years. In addition, an after-tax outflow occurs at the end of the five-year project that has not been included in the operating cash flows: $5 million required for environmental cleanup.
• The required rate of return on natural gas exploration is 18 percent.

The Gasup analyst is unsure about the calculation of the NPV and the IRR because the outlay is staged over two years.

Finally, Dominion Company is evaluating two mutually exclusive projects: The Pinto grinder involves an outlay of $100,000, annual after-tax operating cash flows of $45,000, an after-tax salvage value of $25,000, and a three-year life. The Bolten grinder has an outlay of $125,000, annual after-tax operating cash flows of $47,000, an after-tax salvage value of $20,000, and a four-year life. The required rate of return is 10 percent. The net present value (NPV) and equivalent annual annuity (EAA) of the Pinto grinder are $30,691 and $12,341, respectively. Whichever grinder is chosen, it will have to be replaced at the end of its service life. The analyst is unsure about which grinder should be chosen.

Bohm and his colleague Beth Goldberg have an extended conversation about capital budgeting issues, including several comments listed below. Goldberg makes two comments about real options:

1. The abandonment option is valuable, but it should be exercised only when the abandonment value is above the amount of the original investment.

2. If the cost of a real option is less than its value, this will increase the NPV of the investment project in which the real option is embedded.

Q1:What terminal selling price is required for a 15% internal rate of return on the Richie project? A. $588,028. B. $593,771. C. $625,839.

Q2: The NPV and IRR, respectively, of the Gasup Company investment are closest to:

A. $509,600 and 21.4%. B. $509,600 and 31.3%. C. $946,700 and 31.3%.

Q3:Of the two grinders that the Dominion Company is evaluating, Bohm should recommend the:

A. Bolten grinder because its NPV is higher than the Pinto grinder NPV. B. Bolten grinder because its EAA is higher than the Pinto grinder EAA. C. Pinto grinder because its EAA is higher than the Bolten grinder EAA.

Q4:Are Goldbergs comments about real options correct?

A. No for Comment #1 and Comment #2. B. No for Comment #1 and Yes for Comment #2. C. Yes for Comment #1 and No for Comment #2.