Corporate Finance

Problem 1. The firm Nalyd is considering an investment in equipment to produce a new product. The cost of the equipment is $150,000. This equipment falls into the 5-year asset class and thus would have to be capitalized and depreciated over 6 years at rates 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%. Nalyd expects to use the equipment for three years and then to sell it for $60,000. [Note: you need to pay taxes for the sale amount in excess of the book value.] For the three years of operation, the equipment will generate revenues of $40,000 per year and will have operating costs of $3,000 per year. If the opportunity cost of capital for Nalyd is 12% and its tax rate is 35%, should Nalyd purchase this equipment?

Problem 2. The Baldwin Company is considering investing in a machine that produces bowling balls. The cost of the machine is $100,000 and production is expected to be 8,000 units per year during the 5-year life of the machine. The expected resale value is $5,000 (in real terms). [Note: Numbers in real terms must be discounted at the real rate. Otherwise, we discount at the nominal rate.]

Since the interest in bowling is declining, the management believes that the nominal price of bowling balls will increase at only 2% per year. The nominal price of bowling balls in the first year will be $20. On the other hand, plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production costs are expected to grow at 10% (nominally) per year. First-year nominal production costs will be $10 per unit. The machine will be depreciated to zero on a straight-line basis over five years. The company’s tax rate is 34% and its nominal cost of capital is 15%. The rate of inflation is 5%.

Should the project be undertaken?