Choose one of the following two

Option #1

A manufacturer is considering two alternative machine replacements. Machine 1 costs $1 million with an expected life of 5-years and will generate after-tax cash flows of $350,000 a year. At the end of 5 years, the salvage value on Machine 1 is zero, but the company will be able to purchase another Machine 1 for a cost of $1.2 million. The replacement Machine 1 will generate after-tax cash flows of $375,000 a year for another 5 years. At that time its salvage value will also be zero. The manufacturer’s second option is to buy Machine 2 at a cost of $1.5 million today. Machine 2 will produce after-tax cash flows of $400,000 a year for 10 years, and after 10 years it will have an after-tax salvage value of  $100,000. The cost of capital for both machines is 12 percent.  

1. What is the NPV for both machine 1 and for machine 2?
2. Which machine will have the highest NPV for the firm?
3. Please explain how the selection of the machine with the highest NPV will increase the value of the firm.
4. If the manufacturer chooses the machine that adds the most value to the firm, by how much will the company’s value increase?

Summarize your results in a memo to your employer, letting them know what decision you are recommending and the reason for your recommendation. 

Option #2

WC Development was a well-known real estate development company, whose owner worked long hours with the expectation that his staff would as well. So Bill was not surprised to receive a call from the boss just as Bill was about to leave for a long weekend. 

The development company’s success had been built on a remarkable instinct for a good site. The Owner would exclaim, “Location! Location! Location!” at some point in every planning meeting. Yet finance was not his strong suit. On this occasion he wanted Bill to go over the figures for a new $90 million outlet mall designed to intercept tourists heading into downtown from the airport. “First thing Monday will do just fine,” he said as he handed Bill the file. “I’ll be in away at my house on the beach if you need me.” 

Bill’s first task was to draw up a summary of the projected revenues and costs. The results are shown in the table below. Note that the mall’s revenues would come from two sources: The company would charge retailers an annual rent for the space they occupied, and, in addition, it would receive 5% of each store’s gross sales. 

Construction of the mall was likely to take three years. The construction costs could be depreciated straight-line over 15 years starting in year 3. As in the case of the company’s other developments, the mall would be built to the highest specifications and would not need to be rebuilt until year 17. The land was expected to retain its value but could not be depreciated for tax purposes. 

Construction costs, revenues, operating and maintenance costs, and real estate taxes were all likely to rise in line with inflation, which was forecasted at 2% a year. The company’s tax rate was 35% and the cost of capital was 9% in nominal terms. 

Bill decided first to check that the project made financial sense. He then proposed to look at some of the things that might go wrong. His boss certainly had a nose for a good retail project, but he was not infallible. The Salem Project had been a disaster because store sales had turned out to be 40% below forecast. What if that happened here? Bill wondered just how far sales could fall short of forecast before the project would be underwater. 

Inflation was another source of uncertainty. Some people were talking about a zero long-term inflation rate, but Bill also wondered what would happen if inflation jumped to, say, 10%. 

A third concern was possible construction cost overruns and delays due to required zoning changes and environmental approvals. Bill had seen cases of 25% construction cost overruns and delays up to 12 months between purchase of the land and the start of construction. He decided that he should examine the effect that this scenario would have on the project’s profitability. 

Years

0

1

2

3

4

5-17

Investment:

Land

30

Construction

20

30

10

Operations:

Rentals

12

12

12

Share of retail sales

24

24

24

Operating and maintenance costs

2

4

4

10

10

10

Real estate taxes

2

2

3

4

4

4

(Projected revenues and costs in real terms for the new tourist mall; figures in $ millions).

1. What is the project’s NPV given the projections in the table?
2. Conduct a sensitivity and a scenario analysis of the project. 

Summarize your results in a memo to the owner. What do these analyses reveal about the project’s risks and potential value?