Coursera Wharton Foundation Series

Introduction to Corporate Finance – Professor Franklin Allen

Problem Set 4

1. Select the correct statement(s) from the below choices:

(A) Managers should ignore sunk costs when deciding whether to continue a project or not.

(B) Incidental effects, such as the impact of a branch store on the business of the main store,

are important and should be considered.

(C) We must deduct interest and dividend payments when calculating project cash flows.

(D) We should form our investment decisions around average (not incremental) payoffs.

(E) None of the above choices are correct statements.

2. Economists expect the inflation to be 5%, and the nominal discount rate is 7.5%. George wants

to find the real discount rate. What is the real discount rate?

Please use the following to answer questions 3 through 5.

The Giraffe Corporation is considering two machines, A and B, which cost the same and are

equally effective, but differ with respect to useful lifespan and operating costs. Machine A lasts

for only 3 years, while machine B lasts for 4 years. The cash outflows needed for operating the

machines are:

t = 0 t = 1 t = 2 t = 3 t = 4

A -10 -2 -2 -2

(replace)

B -9 -4 -4 -4 -4

(replace)

Neha is a manager at the Giraffe Corporation. She wants to choose the machine with the lowest

equivalent annual cost (EAC), given that the opportunity cost of capital is 9%.

3. What is the equivalent annual cost (EAC) of machine A?

4. What is the EAC of machine B?

5. Which machine, A or B, should she choose?

Please use the following to answer questions 6 through 11.

[Exam-Type Question] Chioma works for the Furniture Company. She is evaluating a project to

build a factory to manufacture designer chairs.

Item 20X2 20X3 20X4 20X5

Production (chairs) 3,100 3,500 4,000 4,150

Labor (hours) 500 700 900 950

Materials (units) 2,000 2,350 2,700 3,000

Today is 12/31/X1. The initial investment on 12/31/X1 is $500,000. The income tax the firm

faces is 30%, and the firm uses straight-line depreciation. The salvage value of the initial

investment on 12/31/X5 is $50,000. The firm expects to sell all the chairs it produces. The price

that chairs sell for is $200 per chair, and this is expected to be constant over the next decade.

Labor costs are $10 per hour on 12/31/X1 and rise at 5% per year. Materials cost $100 per unit

on 12/31/X1 and grow at 2% per year. All revenue is received at year’s end, and costs are also

paid at year’s end. In other words, we use 12/31/X5 prices for calculating 20X5 revenues and

costs.

The firm has other lines of business that are profitable so that any losses can be offset against

these for tax purposes. All figures are in nominal terms. The nominal discount rate is 15% per

year.

6. What is the labor cost per hour as of 12/31/X5?

7. What is the present value of the investment salvage value?

8. What is the total revenue from sales (price per chair times number of chairs) for the year 20X3?

9. What is the total production cost (labor + materials expenses) for the year 20X5?

10. What is the annual depreciation tax shield, under straight-line depreciation? Note that the tax

code is written in nominal terms.

11. What is the NPV of the project?