Q#1) (40 Marks)

Music Inc. designs musical instruments for the general public and musical artists. Its product base includes standard instruments, which are typically sold to the former customer group and custom instruments sold to the latter group. Music Inc. is presently situated in New York.

The corporation is contemplating opening retail outlets in Nevada. Lee Martin, Music Inc.s senior manager, has been tasked with developing a feasibility report for the expansion plan. He has developed forecasts for the expansion plan for the next six years.

Expansion Plan Forecast Data

Sales: There is a 60% probability of sales being $2,000,000 and a 40% probability of sales being $1,000,000 over the next six years.

Fixed Operating Expenses: are forecasted to be $550,000 over the six-year period.

Variable Operating Expenses: are forecasted at 35% of the forecasted sales for each period.

Tax rate: The applicable tax rate will be 25% with no tax loss benefits.

Market Information: The relevant risk-free rate is 2%, market risk premium is 7% and beta for the project is estimated at 1.50. You are advised to search CAPM (capital asset pricing model) working on google.

Capital Requirement: Music Inc. will require a $175,000 investment in fixed capital which has an estimated life of 10 years and an estimated salvage value of $80,000. The net working capital required at the initiation of the project is $25,000. The project will be financed by issuing firm stock.

Project Life: Six years Event Managers Ltd. and H.S. Creations are two separate parties which have approached Music Inc. and are interested in renting musical instruments. The musical instruments will be used by each of the two parties for musical events. The contract proposed by Event Managers Ltd. is initially set for a four-year period. On the other hand, the contract proposed by H.S. Creations has been initially set for a two-year period. Music Inc.s finance department has evaluated the company will earn $3,500,000 in annual revenues and annually incur $990,000 in rental costs. The corporation will undertake an initial cost of $500,000 for either contact exclusive of annual lost revenues estimated at a present value of $200,000, which could have been earned through selling the rented instruments. The applicable tax rate is 25% and will be discounted using a rate of 12.50%. Due to the uncertainty of rental contracts, Music Inc. has decided to undertake only one project.

Andrew Miller is a finance executive working for Music Inc. Miller believes Martins projections for the expansion project are overly optimistic and the project will not turn out as successful as planned. Millers sales forecasts are more conservative than Martins. Miller has forecasted a 50% chance that annual after-tax operating cash flows will be $2,500,000 and a 50% chance they will be $950,000. He further believes Music Inc. retains the choice to abandon the project in the second year and receive a salvage value of $3,500,000 after receiving the second years cash flows. Miller believes the equipment will have a zero salvage value upon project termination. The projects useful life, initial investment amount, applicable tax rate, and market information is the same as used by Martin in the original analysis.

Chadwick Herring and Lindsey Foley are two employees serving the finance department at Music Inc. Both employees believe that the capital budgeting process, although useful, has its shortfalls. The two employees discuss three shortfalls associated with the process.

Herring Shortfall 1: Capital budgeting assumes economic conditions will continue to remain stable over the period under evaluation. However, in reality conditions are far from stable and may turn a profitable project into a failed venture in the event of an adverse change in conditions.

Foley Shortfall 2: Capital budgeting fails to maintain a long term focus on accounting measures such as return on equity (ROE) and net profit (NP) margin. The consequences of such a shift in focus are manipulated net present values and the acceptance of projects which fail to generate shareholder value.

Herring Shortfall 3: Additionally, costs such as opportunity, sunk, and overhead costs are often difficult to estimate and/or may be ignored producing inaccurate capital budget forecasts.

Their discussion is interrupted by a junior investment officer, Neal Hull, who asks both Herring and Foley the implications of a higher than expected inflation on borrowing costs and depreciation tax shelter for the Nevada expansion project.

In addition to the Nevada expansion project, Music Inc. is considering developing a small musical theatre in Ohio. The estimated construction costs will be $1,500,000 which includes a fixed capital investment of $900,000 and the remainder of the investment allocated to net working capital. These costs will be incurred at the beginning of the project. Annual after-tax operating cash flows are forecasted at $2,345,000 in the first year and will rise by 10% thereafter. The final years after tax operating cash flow includes the equipments after-tax salvage value. The company will apply a 10% discount rate to the project and the capital budget horizon is of 3 years. The applicable tax rate is 25%.

1. Using the initial forecast data compiled by Martin, the after-tax salvage value of the fixed capital investment to be used as part of the Nevada expansion project is closest to:
2. Using the equivalent annual annuity (EAA) approach and assuming no other expenses, which rental contract should Music Inc. undertake? Music Inc. should undertake the contract proposed by:
3. Based on Millers revised forecasts, the expected NPV of the abandonment strategy is closest to:
4. In context of the discussion between Herring and Foley, which of the shortfalls associated with the capital budgeting process has been least accurately identified? 5. the most appropriate response to Hulls query is