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Chapter 4: Q16BP (page 442)

Debby鈥檚 Dance Studios is considering the purchase of new sound equipment that will enhance the popularity of its aerobics dancing. The equipment will cost \(27,900. Debby is not sure how many members the new equipment will attract, but she estimates that her increased annual cash flows for each of the next five years will have the following probability distribution. Debby鈥檚 cost of capital is 15 percent.

Cash Flow Probability

\)4,570 ........................ 0.1

5,550 ........................ 0.3

7,400 ........................ 0.4

9,930 ........................ 0.2

a. What is the expected value of the cash flow? The value you compute will apply to each of the five years.

b. What is the expected net present value?

c. Should Debby buy the new equipment?

Short Answer

Expert verified
  1. The expected value of cash flow of the company is $7,068.
  2. The expected net present value of the company is ($4,764).
  3. No, the company shall not buy the new equipment.

Step by step solution

01

Computation of the expected value of the cash flow

Probability (a)

Cash Flow (b)

Expected Cash flow (a*b)

0.1

$4,570

457

0.3

$5,550

1665

0.4

$7,400

2960

0.2

$9,930

1986

7,068

02

Computation of the expected net present value

Expectednetpresentvalue=Presentvalueofexpectedcashflow-Investment=(7,068脳Presentvaluefactorforannuity@15%,3years)-20,900=(7068脳2.283)-20,900=(4,764)

03

Analysis

The Net present value of the company is ($4,764) i.e., negative net present value. A negative Net present value represents that an investment is unprofitable. Thus, the company shall not opt for the purchase of new equipment.

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Most popular questions from this chapter

The Pan American Bottling Co. is considering the purchase of a new machine that would increase the speed of bottling and save money. The net cost of this machine is \(60,000. The annual cash flows have the following projections:

Year

Cashflow

1

\)23,000

2

26,000

3

29,000

4

15,000

5

8,000

a. If the cost of capital is 13 percent, what is the net present value of selecting a new machine?

b. What is the internal rate of return?

c. Should the project be accepted? Why?

Question: Beverly Hills started a paper route on January 1. Every three months, she deposits $550 in her bank account, which earns 8 percent annually but is compounded quarterly. Four years later, she used the entire balance in her bank account to invest in an investment at 7 percent annually. How much will she have after three more years?

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Question:Masco Oil and Gas Company is a very large company with common stock listed on the New York Stock Exchange and bonds traded over the counter. As of the current balance sheet, it has three bond issues outstanding:

\(150 million of 10 percent series ....... 2026

\)50 million of 7 percent series ........... 2020

\(75 million of 5 percent series ........... 2016

The vice president of finance is planning to sell \)75 million of bonds next year to replace the debt due to expire in 2016. Present market yields on similar Baa-rated bonds are 12.1 percent. Masco also has \(90 million of 7.5 percent noncallable preferred stock outstanding, and it has no intentions of selling any preferred stock at any time in the future. The preferred stock is currently priced at \)80 per share, and its dividend per share is \(7.80.

The company has had very volatile earnings, but its dividends per share have had a very stable growth rate of 8 percent and this will continue. The expected dividend (D1) is \)1.90 per share, and the common stock is selling for \(40 per share. The company鈥檚 investment banker has quoted the following flotation costs to Masco: \)2.50 per share for preferred stock and $2.20 per share for common stock.

On the advice of its investment banker, Masco has kept its debt at 50 percent of assets and its equity at 50 percent. Masco sees no need to sell either common or preferred stock in the foreseeable future as it has generated enough internal funds for its investment needs when these funds are combined with debt financing. Masco鈥檚 corporate tax rate is 40 percent. Compute the cost of capital for the following:

a. Bond (debt) (Kd).

b. Preferred stock (Kp).

c. Common equity in the form of retained earnings (Ke).

d. New common stock (Kn).

e. Weighted average cost of capital.
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