1.

Project Ore and Gano, of equal risk, are alternatives for expanding Midnight
Garden Companys capacity. The firms cost of capital is 13 percent. The cash
flows for each project are shown in the following table.
Project Ore
Project
Gano
Initial
$160,000
$100,000
Investment
Year (t)
Cash Inflows (CFt)
1
$30,000
$30,000
2
40,000
30,000
3
50,000
30,000
4
60,000
30,000
5
70,000
30,000
a. Calculate each projects payback period, NPV, IRR, and MIRR.
b. Summarize the preferences dictated by each measure, and indicate which
project you would recommend. Explain why.
2. Stanforth Research is evaluating the purchase of a highly sensitive
temperature measurement equipment (TME) device. The new device will
replace an existing piece of equipment that was purchased two years ago for
$60,000 and is being depreciated using a five-year recovery period under
MACRS. This equipment has 5 years of useful life and 4 years of depreciation
expense (Years 3,4,5,6) remaining. The new TME will cost $105,000 plus
$3,000 to install and is expected to remain useful for 5 years. If the firm
acquires the new equipment, its working capital needs will change account
recievable will increase $10,000, inventory will increase $5,000 and account
payable will increase $8,000. The projected profits before depreciation and
taxes are shown for both pieces of equipment. The existing equipment can
currently be sold for $25,000 and if its held for 5 more years, the market
value of at the end of year will be $0. The new machine can be sold for
$10,000 before taxes at the end of 5 years. The firm is subject to a 40% tax
rate on both ordinary income and capital gains.

ProfitsbeforeDepreciationandTaxes
Year

Existing
Equipment

New
TME

$156,000

$175,000

160,000

175,000

160,000

180,000

165,000

180,000

$170,000

$185,000

a. Develop the relevant cash flow

needed to analyze the proposed
replacement.
b. Determine the net present value of the proposal if the cost of capital 10%.
Make a recommendation to accept or reject the replacement proposal, and
justify your answer.

3. Tegumi Inc., has made the following forecast of sales, with the associated
probabilities of occurrence noted.
Sales
Probabi
lity
$
0.25
250,000
0.50
500,000
0.25
800,000
The company has fixed operating costs of $50,000 per year, and variable
operating cost represent 35 percent of sales. The existing capital structure
consists of 100,000 shares of common stock that have a $20 per share book
value. No other capital items are outstanding. The marketplace has assigned
the following required returns to risky earnings per shares.
Coefficient of
Variation of
EPS
0.44
0.50
0.52
0.56
0.64
0.91

Estimated
Required
Return rs
10%
11
12
12.5
13
14

The company is contemplating shifting its capital structure by subtituting debt

in capital structure for common stock. The three different debt ratios under
consideration are shown in the following table, along with an estimate, for each
ratio, of the corresponding required interest rate an all debt. The tax rate is 40
percent.
Debt
Interest
Ratio
rate
20%
10%
40
11
60
12
a. Calculate the expected earnings per shares (EPS), the standard deviation of
EPS, and the coefficient of variation of EPS for the three proposed capital
structures.
b. Determine the optimal capital structure. Explain your answer.