Question

3:01 LTE O Notes Done Create a unique hypothetical weighted average cost of capital (WACC) and rate of return. Recommend whether or not the company should expand, and defend your position. e Aa © © © xi _ Hey Happy a wertyuiop a s d f g h i kr azxcvbnm 123 space return

Answer 1

• Problem • Ralph has an investment opportunity which requires an upfront investment of $150 million. • The annual end-of-year cash flows of $14 million dollars are expected to last forever. . The firm's cost of capital is 8%. . Compute the annual EVA and the present value of the project.

Solution • EVA each year is: . The present value of the EVA perpetuity is:

PV = $2 million 8% = $25 million

• EVA When Invested Capital Changes • EVA in Period n (when capital depreciates) . Where C, is a project's cash flow in time period n, In-1 is the project's capital at time n - 1, and ris the cost of capital . When invested capital changes, the EVA rule and the NPV rule continue to coincide.

Ralph is considering an investment in a machine to manufacture rubber chickens. . It will generate revenues of $20,000 each year for 4 years and cost $60,000. The machine is expected to depreciate evenly over the 4 years. . The current interest rate is 5% . Should he invest in the machine?

Using the NPV rule we have a cost of $60,000 and benefits that look like a 4 year annuity. The NPV is • Indicating that this is a valuable endeavor.