Principals of Finance

Problem 1 (10 points)

Digital Systems (DS) has the opportunity to invest $1 million now (at t = 0) and expects after-tax cash flows of $600,000 in t = 1, $700,000 in t = 2 and $650,000 at t = 3. The project will last for three years only. The appropriate cost of capital is 12 percent with all-equity financing, the borrowing rate is 8 percent and DS will borrow $300,000 against the project. This debt must be repaid in three equal installments. Assume debt tax shields have a net value of $0.30 per dollar of interest paid.

Solution:

a) (2 points) Calculate the project base case NPV.

Base case NPV = -1,000,000+600,000/(1.12) + 700,000/(1.12)^2 + 650,000/(1.12)^3

NPV = $556,407.16

b) (8 points) Calculate the project APV (Note: APV = base case NPV + PV[Tax Shields])

Year Debt outstanding at start of the year Interest (8%) Interest tax shield PV

(Tax Shields)

1 300,000 24,000 7,200 6,666.67

2 200,000 16,000 4,800 4,115.23

3 100,000 8,000 2,400 1,905.20

APV = Base case NPV + PV (Tax Shields) = 556,407.16 + (6,666.67 + 4,115.23 + 1,905.20) = 556,407.16 + 12,687.10

APV = $569,094.26

Problem 2 (15 points):

Here are some important figures from the budget of Cornell Inc., for the second qurter of 2007:

April May June

Credit sales $380,000 $396,000 $438,000

Credit Purchase 147,000 175,500 200,500

Cash Disbursements

Wages, taxes and expenses 39,750 48,210 50,300

Interest 11,400 11,400 11,400

Equipment Purchases 83,000 91,000 0

The company predicts that 5% of its credit sales will never be collected, 35% of its sales will be collected in the month of the sales, and the remaining 60% will be collected in the following month. Credit purchases will be paid in the moth following the purchase.

In March 2007, credit sales were $210,000, and credit purchases were $156,000. Using this information, complete the following cash budget:

Solution:

The sales collections each month will be:

Sales...