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The following questions are conceptual questions on several topics that we have discussed in the course. In answering the questions, be clear and to-the-point. The
The following questions are conceptual questions on several topics that we have discussed in the course. In answering the questions, be clear and to-the-point. The motivation of your answer determines the grade.
- Suppose you have to choose between three projects. All involve production technologies that will be repeated at the end of their economic lives. Relevant project information is summarized below. Your supervisor expects a recommendation consistent with shareholder value maximization (his compensation package is linked to the share price of the firm). Which of the projects would you recommend to him, and how can you explain the difference in project rankings between the different capital budgeting criteria? Motivate your answer.
Project | T=0 | T=1 | T=2 | T=3 | IRR | NPV@10% | EA |
A | -$500,000 | $250,000 | $250,000 | $ 200,000 | 19.7% | $84,147 | $33,837 |
B | -$1,000,000 | $500,000 | $750,000 | - | 15.1% | $74,380 | $42,857 |
C | -$1,500,000 | $250.000 | $750,000 | $1,000,000 | 13.1% | $98,422 | $39,577 |
- As part of its efforts to stimulate the economy after the crisis, the Obama administration allowed small businesses to immediately write down capital expenditures for tax purposes. The policy is now being reviewed as part of the discussion on corporate tax reform. One of your colleagues argues that this ultimate form of accelerated depreciation is always beneficial to companies. Another colleague argues that this is not necessarily true, but depends on the salvage value of the asset at the time it is sold. In particular, if a firm sells an asset at a price above book value, accelerated depreciation may be less attractive. A third colleague points out that the depreciation method used by a firm is irrelevant, since depreciation is a non-cash expense, and therefore only affects accounting earnings. Please respond to each of these statements. Who do you agree with and how would you assess the attractiveness of the Obama policy? Motivate your answer.
- American Chemical, a large chemical conglomerate, is planning to buy the Paper division of Du Pont. A Stern student doing an internship at the firm has been asked to identify the correct cost of capital of American Chemical after the acquisition and collected the following firm and financial market information. The student established that all firms in the table pay corporate taxes at a 35% rate, and estimated a market risk premium of 6%. The target capital structure for the acquisition is 50% debt. American Chemicals target capital structure has 40% debt and Du Ponts Paper division has 30% debt. Describe clearly how the student should proceed in estimating the correct cost of capital. Motivate your input choices, discuss any additional information you would need and show the steps (You can include any formulas you would use)
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