RSM333 - Assignment #1 - Fall 2012
RSM333 - Assignment #1 - Fall 2012 You may work in groups of up to 3. Due 4pm at Rotman Commerce, October 10, 2012 50 MARKS TOTAL
Question 1 - 10 marks Mad Cat Inc. is debating between two alternative earth moving machines to use for the next 8 years. The first supplier, Double Candle, offers the necessary machinery (CCA rate = 30%) at an upfront cost of $5,450,000. These machines are expected to last 4 years and then be salvaged for approximately $1,400,000 (the CCA pool remains open). All the Double Candle machines would be salvaged and replaced after 4 years. The alternative is to purchase significantly more expensive (but longer lasting) machinery from Elemental which would last the full 8 years but cost $8,650,000 and depreciate at the same CCA rate. Elemental's machines have an expected salvage value of approximately $1,800,000. Mad Cat pays a 25% tax rate and its cost of capital is 11%. a) Which of the two systems incurs the lowest overall cost for Mad Cat? (4 marks) b) Making projections about cash flows in the future can be quite a difficult task for junior analysts. For what salvage value on the Elemental machines would you be indifferent between the two options? (2 marks) c) At what price for the Elemental machines would you be indifferent between the two options (assuming $1,000,000 in salvage regardless of the purchase price). (2 marks) d) How would you feel about your original decision in part a) if Element instead offered to let you finance the purchase for $1,450,000 per year for 8 years with each payment made at the beginning of each year. The arrangement would enable Mad Cat to depreciate the asset as though it was owned the entire time, and to salvage it at the end of its useful life (a financial lease - the payments are not tax deductible). (2 marks)
Question 2 - 10 marks Frozen Waste Oilfields is a new producer of crude oil from frozen tar sand deposits, able to extract 2,500,000 barrels of oil each year at a cost of roughly $40 per barrel. In addition, the firm incurs $10 million in unavoidable overhead each year. Its cost of capital is 18% and its tax rate is 35% a) If it can suspend operations, below what price should the firm cease producing output? (2 marks) b) Although oil prices have recently fallen to approximately $45 per barrel, the firm's forecasters believe that over the next year, there is a 30% chance that the average price per barrel will rise to $60, a 45% chance the price will stay at $45, and a 25% chance the price falls to $35. Frozen Waste pays a 30% tax rate and all cash flows take place at the end of the year. Assuming the firm will know at the beginning of the year what the price of its output will be, what is the value of the option for it to suspend operations for a year? (8 marks)
Question 3 - 10 marks The engineering department of your firm is developing a clever new production system which it believes could be put into use immediately, despite the fact that it has not been fully tested (and thus its ultimate benefits remain uncertain for the time being). The Skynet mainframe will control all aspects of the production system and while it will incur an initial cost of $10 million dollars to set up, it is expected to reduce operating costs by $2 million a year for the next 15 years. Work in progress inventory will be reduced by $2 million (one time) by the end of the first year with a further improvement of $1 million expected in the second year (also a one-time improvement). As the system could be perpetuated for the foreseeable future, these reductions in working capital would be permanent. Skynet will have an 8% CCA rate (pool remains open) and no salvage value. Your firm’s tax rate is 40% and the WACC is 12%. a) Based on this information, should you initiate the project? (3 marks) Regarding, the project’s uncertainty, your engineers inform you about an “instability” in the system that might result in production disruptions without warning. If this happens, the entire process halts (resulting in net after-tax costs of $2,000 per minute) for an average of 30 minutes while the system re-boots. The possibility of this happening on any given day is approximately 1% which is expected to result in an average of 3.65 incidents a year. b) With this new information to consider, what is the NPV of the project now? (2 marks) c) Identify and discuss two risks that are ignored by this analysis? (2 marks) Addressing your concerns, the engineers tell you that if they spend $1.1 million immediately (after-tax), that additional research could be initiated to work out the bugs in the system such that with 90% probability, Skynet could be installed next year with no risk of downtime. If the projects don’t succeed, it won’t change the system’s operating reliability (but we won't know until next year if they succeed or not). d) Should you wait to install the system and invest in the additional research? (3 marks)
Question 4 - 10 marks a) Your boss provides you with the following specifications for a new machine that she heard about at a trade show which would reduce operating costs in your department each year. The machine will cost $500,000 but is estimated to result in a $150,000 pre-tax annual saving for the next 5 years. It falls into Class 8 for CCA purposes (CCA rate is 20%/year), will have a salvage value of $100,000, and the asset pool will remain open after the project is complete. An initial investment in inventory and accounts receivable of $45,000 will be required (recovered at the end of the project’s life), as well as $4000 in pre-tax annual maintenance costs. Your firm’s tax rate is 30% and its after-tax cost of debt (the appropriate discount rate in this case) is 12%. She has asked for your evaluation of the opportunity: should the machine be acquired? (4 marks) b) Alternately, the machine can be rented as an operating lease for the next five years for yearly payments of $115,000, paid at the beginning of each year. Although the machine’s maintenance will be taken care of by the lessor, tax benefits from making the lease payments will not be incurred until the end of each year. Does the option to lease change your decision in part a? Should you lease or buy the machine? (6 marks)
Question 5 - 10 marks It is January 3rd, 2012 and Google Inc. (GOOG) stock is currently trading on the Nasdaq at a price of $647 US dollars. Using the information provided below, please answer the following questions: (Note: 'Last' means last traded price of the put or call option. Use this number for your calculations).
a) Which option is 'in-the-money' and by how much? (2 marks) b) Using the relationship Option Value = IV + TV and the above data, calculate IV and TV for each of the calls and puts. Which option has more time value and why? Which option has more intrinsic value and why? (5 marks) c) Assume an investor is holding 100 shares of Google in his stock portfolio and the company's earnings will be released on February 16th, after the market closes. The investor is worried that earnings results may not meet the market's expectations and would like to hedge his 100 shares of Google. Using the above data, what can the investor do and how much will it cost him? How long will he have to keep this hedge on for? (3 marks)
Question 1 - 10 marks Mad Cat Inc. is debating between two alternative earth moving machines to use for the next 8 years. The first supplier, Double Candle, offers the necessary machinery (CCA rate = 30%) at an upfront cost of $5,450,000. These machines are expected to last 4 years and then be salvaged for approximately $1,400,000 (the CCA pool remains open). All the Double Candle machines would be salvaged and replaced after 4 years. The alternative is to purchase significantly more expensive (but longer lasting) machinery from Elemental which would last the full 8 years but cost $8,650,000 and depreciate at the same CCA rate. Elemental's machines have an expected salvage value of approximately $1,800,000. Mad Cat pays a 25% tax rate and its cost of capital is 11%. a) Which of the two systems incurs the lowest overall cost for Mad Cat? (4 marks) b) Making projections about cash flows in the future can be quite a difficult task for junior analysts. For what salvage value on the Elemental machines would you be indifferent between the two options? (2 marks) c) At what price for the Elemental machines would you be indifferent between the two options (assuming $1,000,000 in salvage regardless of the purchase price). (2 marks) d) How would you feel about your original decision in part a) if Element instead offered to let you finance the purchase for $1,450,000 per year for 8 years with each payment made at the beginning of each year. The arrangement would enable Mad Cat to depreciate the asset as though it was owned the entire time, and to salvage it at the end of its useful life (a financial lease - the payments are not tax deductible). (2 marks)
Question 2 - 10 marks Frozen Waste Oilfields is a new producer of crude oil from frozen tar sand deposits, able to extract 2,500,000 barrels of oil each year at a cost of roughly $40 per barrel. In addition, the firm incurs $10 million in unavoidable overhead each year. Its cost of capital is 18% and its tax rate is 35% a) If it can suspend operations, below what price should the firm cease producing output? (2 marks) b) Although oil prices have recently fallen to approximately $45 per barrel, the firm's forecasters believe that over the next year, there is a 30% chance that the average price per barrel will rise to $60, a 45% chance the price will stay at $45, and a 25% chance the price falls to $35. Frozen Waste pays a 30% tax rate and all cash flows take place at the end of the year. Assuming the firm will know at the beginning of the year what the price of its output will be, what is the value of the option for it to suspend operations for a year? (8 marks)
Question 3 - 10 marks The engineering department of your firm is developing a clever new production system which it believes could be put into use immediately, despite the fact that it has not been fully tested (and thus its ultimate benefits remain uncertain for the time being). The Skynet mainframe will control all aspects of the production system and while it will incur an initial cost of $10 million dollars to set up, it is expected to reduce operating costs by $2 million a year for the next 15 years. Work in progress inventory will be reduced by $2 million (one time) by the end of the first year with a further improvement of $1 million expected in the second year (also a one-time improvement). As the system could be perpetuated for the foreseeable future, these reductions in working capital would be permanent. Skynet will have an 8% CCA rate (pool remains open) and no salvage value. Your firm’s tax rate is 40% and the WACC is 12%. a) Based on this information, should you initiate the project? (3 marks) Regarding, the project’s uncertainty, your engineers inform you about an “instability” in the system that might result in production disruptions without warning. If this happens, the entire process halts (resulting in net after-tax costs of $2,000 per minute) for an average of 30 minutes while the system re-boots. The possibility of this happening on any given day is approximately 1% which is expected to result in an average of 3.65 incidents a year. b) With this new information to consider, what is the NPV of the project now? (2 marks) c) Identify and discuss two risks that are ignored by this analysis? (2 marks) Addressing your concerns, the engineers tell you that if they spend $1.1 million immediately (after-tax), that additional research could be initiated to work out the bugs in the system such that with 90% probability, Skynet could be installed next year with no risk of downtime. If the projects don’t succeed, it won’t change the system’s operating reliability (but we won't know until next year if they succeed or not). d) Should you wait to install the system and invest in the additional research? (3 marks)
Question 4 - 10 marks a) Your boss provides you with the following specifications for a new machine that she heard about at a trade show which would reduce operating costs in your department each year. The machine will cost $500,000 but is estimated to result in a $150,000 pre-tax annual saving for the next 5 years. It falls into Class 8 for CCA purposes (CCA rate is 20%/year), will have a salvage value of $100,000, and the asset pool will remain open after the project is complete. An initial investment in inventory and accounts receivable of $45,000 will be required (recovered at the end of the project’s life), as well as $4000 in pre-tax annual maintenance costs. Your firm’s tax rate is 30% and its after-tax cost of debt (the appropriate discount rate in this case) is 12%. She has asked for your evaluation of the opportunity: should the machine be acquired? (4 marks) b) Alternately, the machine can be rented as an operating lease for the next five years for yearly payments of $115,000, paid at the beginning of each year. Although the machine’s maintenance will be taken care of by the lessor, tax benefits from making the lease payments will not be incurred until the end of each year. Does the option to lease change your decision in part a? Should you lease or buy the machine? (6 marks)
Question 5 - 10 marks It is January 3rd, 2012 and Google Inc. (GOOG) stock is currently trading on the Nasdaq at a price of $647 US dollars. Using the information provided below, please answer the following questions: (Note: 'Last' means last traded price of the put or call option. Use this number for your calculations).
a) Which option is 'in-the-money' and by how much? (2 marks) b) Using the relationship Option Value = IV + TV and the above data, calculate IV and TV for each of the calls and puts. Which option has more time value and why? Which option has more intrinsic value and why? (5 marks) c) Assume an investor is holding 100 shares of Google in his stock portfolio and the company's earnings will be released on February 16th, after the market closes. The investor is worried that earnings results may not meet the market's expectations and would like to hedge his 100 shares of Google. Using the above data, what can the investor do and how much will it cost him? How long will he have to keep this hedge on for? (3 marks)
