End of Chapter Questions: 9.5 Why is capital rationing a special case of mutual exclusivity? 9.7 Which three factors can create ranking problems among mutually exclusive projects? Explain each factor and show how the associated ranking problem can be overcome. 9.9 What is the most used method of incorporating risk into project appraisal? Why is it so often chosen over competing methods? 9.20 What are the benefits of using non-discounted methods of project appraisal? Why are non-discounted methods of project appraisal considered inferior to the discounted cash flow methods? 9.21 Using an example, explain why using non-financial factors to override the decision from a quantitative analysis may be inconsistent with wealth maximisation in the short run, but consistent with it in the long run. Financial Problems: 9.3 Daisy Chain Shoes is a small company that has limited access to funds. They currently have a capital rationing constraint of S500 000 and have asked you to recommend which investments they should make. Each investment can only be undertaken one time and more than one project will be undertaken. The proposed investments are: Project Initial Investments NPV Stilettos 60000 Platforms 230000 61 000 Sling backs 150000 15000 Creepers 95000 20000 Thongs 35000 15000 The management of Daisy Chain will only raise the amount of funds required to invest in the set of projects that will maximise the owners' wealth. (a) Identify the wealth maximising set of projects from those available to Daisy Chain 125000 (b) How much money should Daisy Chain raise to fund these projects? 9.5 As the financial manager of Nesbitt Ltd, you are currently evaluating three different mixing machines that could be used in the Hobgoblin expansion project. Each machine has an expected life of 5 years. However, the initial outlays for each machine and their potential cash flow patterns are quite different. The project has a 12% required return and you have made the following calculations: NPV IRR Mix-Right 520000 13% Mix-O-Matic 55000 12.25% Whizzer $15000 15% (a) Identify any disparities in the ranking of the projects and explain why these disparities might occur. (b) Which project would you choose? Why? 9.11 Minx Ltd is evaluating a project to manufacture faux fur. The equipment and set-up costs for the project will total $2.1 million. The equipment will be depreciated straight line over a seven-year effective life. Sales of $900 000 per annum are expected and cash operating costs will be 30% of sales. The project will run for 7 years and will have a zero salvage value. The corporate tax rate is 30%. The marginal shareholder of Minx is a foreign investor and the after- tax required return is 13% (a) Estimate the relevant cash flows. Round your calculations for each cash inflow or outflow to the nearest whole dollar. Calculate the NPV for the project. (b) Assume that Minx is currently losing money on another major project. It does not expect to have a taxable income for the first three years of the faux fur project. Estimate the relevant cash flows and NPV of the project under these circumstances. Is your recommendation on the project different under this scenario? Determine the relevant cash flows for the project and calculate the NPV using a required return of 10%. Show all relevant equations and calculations. Should the ordering system be changed? 9.19 Your brother owns a rental property and needs to replace the hot water system. He has provided you with the following three alternatives: A solar system which would cost $9000 to install and $200 annual operating costs. The system will last for 30 years and you can assume that the building will too. A gas system which would cost $3000 to install and $800 p.a. operating costs. This system would have a useful life of 15 years An electric system with a cost of $2500 to install and $1200 p.a. operating costs. This system would have a useful life of 12 years (a) If your brother's cost of capital is 12% and the hot water systems do not generate any tax benefits, which system would you recommend to maximise your brother's wealth? (b) Are there any non-financial factors your brother might consider in his investment decision? 9.18 McAuber & Sons are a family owned partnership that sells books by mail order. Partnership income is shared among the three partners who all have a marginal tax rate of 47%. The corporate tax rate is 30%. The youngest partner has suggested that posting catalogues and asking customers to return order forms by mail is a bit outdated. She has suggested that the firm set up an online catalogue that allows customers to order books and pay using a credit card from the customer's computer. The computerised system would replace the current mail system. The current mail system used by McAuber costs $15 per 100 customers to process. Each customer spends an average of $30 per order and this is expected to continue under the new system. Netlink Ltd have agreed to design and maintain the McAuber & Sons website for an upfront fee of $500 000. There will also be an ongoing service fee of $10 per 100 customers that order from the website. The contract with Netlink is for 4 years. At the end of 4 years, the entire ordering system will be reviewed. If McAuber decide to terminate the contract with Netlink prior to the contract date, they will have to pay Netlink a penalty of $100 000. The new online advertising and ordering system is expected to increase sales from the current level of $750 000 p.a. to $1.2 million p.a. for the next 4 years