Capital Budgeting

| December 15, 2015

Capital Budgeting

You are considering starting a new firm. According to the relevant tax code, you will pay 15%on the first $500,000 of earnings each year, and 50% on anything above that.For the venture, you will need to purchase a piece of machinery for $1,650,000 immediately.This equipment will be depreciated by the ten-year MACRS schedule. It will have an operatinglife of ten years. At that point it can be sold for a real value of $150,000 (in today’s dollars). You estimate that sales in the first year will have a real value of $480,000. Then you expect realsales to grow at 6% per year. You expect real annual fixed costs to be $85,000. Variable costswill be 25% of sales, which means that their real value will also grow by 6% per year.At the outset you will require a stock of $70,000 in net working capital. After that, net workingcapital requirements should be about 15% of sales.(1) Calculate the Net Present Value for the project at an inflation rate of 0%, and a 16% discountrate.(2) Calculate the Net Present Value for the project at an inflation rate of 0%, and a 13% discountrate.(3) Now, consider a low-inflation environment. Calculate the Net Present Value for the project atan inflation rate of 3%, and a 16% discount rate.(4) Calculate the Net Present Value for the project at a 16% discount rate, assuming that bothfixed and variable costs rise at an annual rate of 6%, and all other relevant values rise at a rate of3%.(5) Now, consider a high-inflation environment. Calculate the Net Present Value for the projectat an inflation rate of 20%, and a 33% discount rate.

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