Lazy Q Ranches, one of the largest ranching consortiums in the world, is considering two projects. The first project, building a resort on one of its ranches in Montana and the other is to expand into Argentina and raise racehorses. The analysis is being done assuming a 10 year life for both projects. Lazy Q has a corporate tax rate of 25%, a required rate of return of 12% on projects and has a weighted average cost of capital of 6%. Details of the two options are provided as follows:
Resort Project:
The resort project would require a $20,500,000 investment. At the end of ten years, some of the equipment would have a salvage value of $300,000. The project would require additional working capital $450,000 in the form of an increase in the minimum balance required by their bank and this working capital would be released at the end of the project. The project would provide estimated net income each year as follows:
Sales............................................................... ..................... $6,500,000
Less variable expenses................................... 4,275,000
Contribution margin...................................... .............. $2,225,000
Less fixed expenses:
Fixed expenses*................................. .............................. $1,115,000
Net income.................................................... ................... $1,111,000
*Depreciation is 10% of fixed expenses
Race Horse Project:
The race horse project would require a $10,875,000 investment. At the start of the project current buildings that are on the land being purchased to create the new facilities will be torn down and sold for scrap wood for $190,000. At the end of ten years, some of the equipment would have a salvage value of $80,000. The project would require additional working capital $210,000 in the form of an increase in the minimum balance required by their bank and this working capital would be released at the end of the project. The project would provide estimated net income each year as follows:
Sales............................................................... ................... $4,125,000
Less variable expenses................................... 1,900,000
Contribution margin...................................... ............. $2,225,000
Less fixed expenses:
Fixed expenses*................................. ............................ $ 775,000
Net income.................................................... .................. $1,475,000
*Depreciation is 8% of fixed expenses
Required:
A. For both projects compute the project’s net present value.
B. For both projects compute the project’s internal rate of return, to the nearest percentage.
C. What is the profitability index for each project? Explain what these indices mean.
D. For both projects compute the project’s payback period.
E. What would be the payback period for both projects if the annual revenues for each project were estimated to be:
Year |
Resort Project Revenues |
Racehorse Project Revenues |
1 |
6,000,000 |
4,000,000 |
2 |
6,250,000 |
4,000,000 |
3 |
6,250,000 |
4,125,000 |
4 |
6,300,000 |
4,150,000 |
5 |
6,250,000 |
4,150,000 |
6 |
6,225,000 |
4,200,000 |
7 |
6,500,000 |
4,250,000 |
8 |
6,450,000 |
4,300,000 |
9 |
6,400,000 |
4,350,000 |
10 |
6,200,000 |
4,400,000 |
F. For both projects compute the simple rate of return.
G. Should the company accept the project? Why or why not?
A)
Taking weighted average cost of capital as discounting factor
Caculation of yearly cash inflow :
Resort. Race horse
Net income before tax. 1115000. 1475000
Less: tax@25%. 277500. 368750
Net income after tax. 832500. 1106250
Add: Depreciation.
(10%of1115000). 111500
(8%of775000). 62000
Cash inflow. 944000. 1168250
Present value of net cash inflow @6%=7.360*cash inflow yearly
Resort. Race horse
Present value
(7.360*944000). 6947840
(7.360*1168250). 8598320
Add PV of Salvage value.
And working capital realised 418500
.(0.558 *750000)
(0.558*290000). 161820
Total. 7366340. 8760140
Less initial cash out flow ( 2050000). (10875000)
Net present value 5316340. (2114860)
Lazy Q Ranches, one of the largest ranching consortiums in the world, is considering two projects....
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