Question 1
Comparing Investment Criteria. Define each of the following investment rules and discuss any potential shortcomings of each. In your definition, state the criterion for accepting or rejecting independent projects under each rule.
a. Payback period b. Average accounting return c. Internal rate of return d. Profitability index e. Net present value
Question 2
Net Present Value. One potential criticism of the net present value technique is that there is an implicit assumption that this technique assumes the intermediate cash flows of the project are reinvested at the required return. In other words, if you calculate the future value of the intermediate cash flows to the end of the project at the required return, sum the future values, and find the net present value of the two cash flows, you will get the same net present value as the original calculation. If the reinvestment rate used to calculate the future value is lower than the required return, the net present value will decrease. How would you evaluate this criticism?
Question 3.
Internal Rate of Return. One potential criticism of the internal rate of return technique is that there is an implicit assumption that this technique assumes the intermediate cash flows of the project are reinvested at the internal rate of return. In other words, if you calculate the future value of the intermediate cash flows to the end of the project at the required return, sum the future values, and calculate the internal rate of return of the two cash flows, you will get the same internal rate of return as the original calculation. If the reinvestment rate used to calculate the future value is different than the internal rate of return, the internal rate of return calculated for the two cash flows will be different. How would you evaluate this criticism?
Closing case
BUNYAN LUMBER, LLC
Bunyan Lumber, LLC, harvests timber and delivers logs to timber mills for sale. The company was founded 70 years ago by Pete Bunyan. The current CEO is Paula Bunyan, the granddaughter of the founder. The company is currently evaluating a 7,500-acre forest it owns in Oregon. Paula has asked Steve Boles, the company's finance officer, to evaluate the project. Paula's concern is when the company should harvest the timber.
Lumber is sold by the company for its "pond value." Pond value is the amount a mill will pay for a log delivered to the mill location. The price paid for logs delivered to a mill is quoted in dollars per thousands of board feet (MBF), and the price depends on the grade of the logs. The forest Bunyan Lumber is evaluating was planted by the company 20 years ago and is made up entirely of Douglas fir trees. The table below shows the current price per MBF for the three grades of timber the company feels will come from the stand:
TIMBER GRADE/ PRICE PER MBF
1P-$575
2P-555
3P-530
Steve believes that the pond value of lumber will increase at the inflation rate. The company is planning to thin the forest today, and it expects to realize a positive cash flow of $450 per acre from thinning. The thinning is done to increase the growth rate of the remaining trees, and it is always done 20 years following a planting.
The major decision the company faces is when to log the forest. When the company logs the forest, it will immediately replant saplings, which will allow for a future harvest. The longer the forest is allowed to grow, the larger the harvest becomes per acre. Additionally, an older forest has a higher grade of timber. Steve has compiled the following table with the expected harvest per acre in thou- sands of board feet, along with the breakdown of the timber grade.
|
Years from today to begin harvest
|
Harvest (MBF) per acre
|
Timber grade (See next)
|
1p
|
2p
|
3p
|
|
20
|
7.2
|
|
15%
|
42%
|
43%
|
|
25
|
9.4
|
|
18
|
49
|
33
|
|
30
|
11.3
|
|
20
|
51
|
29
|
|
35
|
12.2
|
|
22
|
53
|
25
|
The company expects to lose 5 percent of the timber it cuts due to defects and breakage. The forest will be clear-cut when the company harvests the timber. This method of harvesting allows for faster growth of replanted trees. All of the harvesting, processing, replanting, and transportation are to be handled by subcontractors hired by Bunyan Lumber. The cost of the logging is expected to be $155 per MBF. A road system has to be constructed and is expected to cost $60 per MBF on average. Sales preparation and administrative costs, excluding office overhead costs, are
expected to be $21 per MBF. As soon as the harvesting is complete, the company will reforest the land.
PER ACRE COST
Excavator piling-$160
Broadcast burning-280
Site preparation-140
Planting costs-270
Reforesting costs include the following:
All costs are expected to increase at the inflation rate. Assume all cash flows occur at the year of harvest. For example, if the company begins harvesting
the timber 20 years from today, the cash flow from the harvest will be received 20 years from today. When the company logs the land, it will immediately replant the land with new saplings. The harvest period chosen will be repeated for the foreseeable future. The company's nominal required return is 10 percent, and the inflation rate is expected to be 3.7 percent per year. Bunyan Lumber has a 35 percent tax rate.