Principles of Financial Management
Questions 1-5 540
Problems 1, 2, 7-10, 12, & 17 541-545
.QUESTIONS 1-5.
1. In 1983 the Bell Telephone System, which operated as AT&T, was broken up, resulting in the creation of seven regional telephone companies. AT&T stockholders received shares of the new companies and the continuing AT&T, which handled long distance services. Prior to the breakup, telephone service was a regulated public utility. That meant AT&T had a monopoly on the sale of its service, but couldn't charge excessive prices due to government regulation. Regulated utilities are classic examples of low risk - modest return companies. After the breakup, the "Baby Bells," as they were called, were freed from many of the regulatory constraints under which the Bell System operated, and at the same time had a great deal of money. The managements of these young giants were determined to be more than the staid old-line telephone companies they'd been in the past. They were quite vocal in declaring their intentions to undertake ventures in any number of new fields, despite the fact that virtually all of their experience was in the regulated environment of the old telephone system. Many stockholders were alarmed and concerned by these statements. Comment on what their concerns may have been.
2. A random variable is defined as the outcome of one or more chance processes. Imagine that you're forecasting the cash flows associated with a new business venture. List some of the things that come together to produce cash flows in future periods. Describe how they might be considered to be outcomes of chance processes and therefore random variables. Cash flow forecasts for a project are put together by using Equations (10-1) and (10-2) to calculate the project's NPV and IRR. That makes NPV and IRR random variables as well. Is their variability likely to be greater or less than the variability of the individual cash flows making them up?
3. One of the problems of using simulation to incorporate risk into capital budgeting is related to the idea that the probability distributions of successive cash flows usually are not independent. If the first period's cash flow is at the high end of its range, for example, flows in subsequent periods are more likely to be high than low. Why do you think this is generally the case? Describe an approach through which the computer might adjust for this phenomenon to portray risk better.
4. Why is it desirable to construct capital budgeting rules so that higher risk projects become less acceptable than lower risk projects?
5. Rationalize the appropriateness of using the cost of capital to analyze normally risky projects and higher rates for those with more risk.
1. The Glendale Corp. is considering a real estate development project that will cost $5M to undertake and is expected to produce annual inflows between $1M and $4M for two years. Management feels that if the project turns out really well the inflows will be $3M in the first year and $4M in the second. If things go very poorly, on the other hand, inflows of $1M followed by $2.5M are more likely. Develop a range of NPVs for the project if Glendale's cost of capital is 12%.
2. If Glendale's management in the last problem attaches a probability of .7 to the better outcome, what is the project's most likely (expected) NPV?
7. Using the information from the previous problem, randomly select four NPV outcomes from the data. (Select one cash flow from each year and compute the project NPV and the probability of that NPV implied by those selections.) Do your selections give a sense of where NPV outcomes are likely to cluster?
"See below for the information for #6 the previous problem as it is answered."
"Sanville Quarries is considering acquiring a new drilling machine which is expected to be more efficient than their current machine. The project is to be evaluated over four years. The initial outlay required to get the new machine operating is $675,000. Incremental cash flows associated with the machine are uncertain, so management developed the following probabilistic forecast of cash flows by year ($000). Sanville's cost of capital is 10%.
Year1Prob Year2 Prob Year3Prob Year4Prob
$150 .30 $200 .35 $350 .30 $300 .25
$175 .40 $210 .45 $370 .25 $360 .35
$300 .30 $250 .20 $400 .45 $375 .40
a. Calculate the project's best and worst NPVs and their probabilities.
b. What is the value of the most likely NPV outcome?
SOLUTION: ($000)
Best Worst Most Likely
CFo (675) (675) (675)
C01 300 150 205
C02 250 200 214.5
C03 400 350 377.5
C04 375 300 351
I 10 10 10
NPV 360.995 94.517 211.995
Notice that calculating the most likely outcome requires taking the mean of each cash flow distribution.
Probbilities:
Best: (.3)(.2)(.45)(.4) = .01080
Worst: (.3)(.35)(.3)(.25) = .00788
Decision Trees:
8. Northwest Entertainment Inc. operates a multiplex cinema that has nine small theaters in one building. Business has been good lately and management is considering a project that will add five screens at an estimated cost of $3 million. The success of the expansion depends on whether local demand over the next two years will support the additional capacity. Demand is believed to depend on the local economy. An economist at a nearby university has predicted a 90% probability of continued prosperity in the area and a 10% chance of a moderate downturn. Management feels that if prosperity continues the new theaters will generate a profit margin of $2 million in the first year and $3 million in the second. A moderate downturn would produce contributions of $1.5 and $2 million. Northwest's cost of capital is 12%.
a. Draw a decision tree for the project.
b. Calculate the NPV along each path.
c. Develop the probability distribution of the project's NPV.
d. Calculate the project's expected NPV.
e. Make a recommendation on the project with an appropriate comment on risk.
More Complex Decision Trees:
9. Work Station Inc. manufactures office furniture. The firm is interested in "ergonomic" products that are designed to be easier on the bodies of office workers' who suffer from aliments such as back and neck pain due to sitting for long periods. Unfortunately customer acceptance of ergonomic furniture tends to unpredictable, so a wide range of market response is possible. Management has made the following two-year, probabilistic estimate of the cash flows associated with the project arranged decision tree format ($000).
Work Station is a relatively small company, and would be seriously damaged by any project that lost more than $1.5 million. The firm's cost of capital is 14%.
a. Develop a probability distribution for NPV based on the forecast. I.e., calculate the project's NPV along each path of the decision tree and the associated probability.
b. Calculate the project's expected NPV.
c. Analyze your results and make a recommendation about the project's advisability considering both expected NPV and risk
Abandonment Options:
10. Resolve the last problem assuming Work Station Inc has an abandonment option at the end of the first year under which it will recover $5 million of the initial investment in year 2. What is the value of the ability to abandon the project? How does your overall recommendation change?
Real Options: Example 12-4 (page 537)
12. Vaughn Clothing of the previous problem has a real option possibility. Carlson Flooring has expressed an interest in trading buildings with Vaughn after Vaughn's is refurbished. Carlson has offered to reimburse Vaughn for 70% of its refurbishment costs at the end of the first year if they make the trade. Vaughn would then forego all incremental cash flows for the second year. Carlson is willing to keep the option open for one year in return for a non-refundable payment of $150,000 now. Should Vaughn pay the $150,000 to keep the option available?.
17. Crest Concrete Inc. has been building basements and slab foundations for new homes in La Crosse, Wisconsin for more than 20 years. However, new home sales have slowed recently and residential construction work is hard to get. As a result, management is considering a venture into commercial construction. Although Crest would still be pouring concrete in commercial building, almost everything else about the business differs substantially from homebuilding which is all the firm has done until now.
The local commercial concrete business is dominated by two firms. Readi-Mix Inc., and Toddy Concrete Inc. Readi-Mix has been in business for 50 years, has a market share of 70%, and a beta of 1.3. Toddy has been in the area for only five years and has a beta of 2.4. Crest's own beta is .9 and its cost of capital is 9.3%. Both of these were developed during a long period in which the housing market was prosperous and growing steadily. The stock market is currently returning 11% and treasury bills are yielding 4.2%.
Crest will have to spend $950,000 to get started in the commercial field, and expects net cash inflows of $250,000 in the first year, $400,000 in the second year and $700,000 in the third.
Should Crest give commercial construction a try?