FINA 301 2012

TUTORIAL ASSIGNMENT 5

1. A project involving the production of a new product will involve purchase of an item of equipment costing $2.2m, expected sales of 1 million units p.a. for three years, a sale price of $2 in the first year inflating at 3% p.a thereafter, expected operating costs of $1m in the first year inflating at 3% p.a. thereafter, tax depreciation of 40% DV (diminishing value), and no salvage value on the equipment in three years. In addition, the company tax rate is 28%. The probability distribution of X1/E0(X1) is believed to have standard deviation .25, the same for X2/E1(X2), and the "expectations revision coefficient" is believed to be 1. In respect of the discount rate, the appropriate unlevered beta is estimated at . 80, leverage at 30%, the debt risk premium is .018, the risk free rate is .06 and the market risk premium in the tax-adjusted version of the CAPM is .07. A Miller tax world is believed to prevail. The item of equipment could be sold in one year for $1.4m and in two years for $0.7m. (a) (b) (c) What is the NPV of the project? Redo (a) without the abandonment options. Accordingly what are the abandonment options worth? Directly value each of the two abandonment options.

2. A project costs $2m now and this is expected to inflate at 3% per year. The expectation now of the cash flow in year 1 is $0.15m and this is expected to inflate at 3% p.a. The probability distribution of X1/E0(X1) is believed to have standard deviation .25, the same for X2/E1(X2), and the "expectations revision coefficient" is believed to be 1. The appropriate discount rate is 10%. (a) (b) If deferral of the project for 1 or 2 years is possible, what is the optimal course of action now and the NPV now. What is the NPV now in the absence of a deferral option, and hence the value of the deferral option.

3 (a) A forest costs $1m to plant now, and has ongoing maintenance costs of $0.1m per year until felled. Felling costs are $40m. Revenue is expected to be $96.8m, $110m, $121m if cut in 26, 28, 30 years respectively [all $ in current prices]. The expected inflation rate is 2%, Tc = .28, and the appropriate discount rate is 11%. Also, tax deductible expenditures can only be deducted against the future forestry revenues from this project. What is the (tentatively) optimal felling frequency? Check 26, 28, 30 years. (b) An existing forest if felled now (at a felling cost of $40m) would yield revenue of $100m. If felling is deferred for 1, 2 years, revenue is expected to increase to $105m and $110m respectively. Ongoing maintenance cost would be $0.1m p.a. [all $ in current prices]. Should this forest be felled now? (c) Compare your answers here with those in the lecture example, in which tax deductible expenditures were immediately deductible against revenues from other activities.