Please show your work step by step USING A CALCULATOR.

Problem 12-18

Scenario analysis

Your firm, Agrico Products, is considering a tractor that would have a cost of $37,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of $7,400 per year, beginning the first year. (Thus, annual cash flows would be $12,000 before taxes plus the tax savings that result from $7,400 of depreciation.) The managers are having a heated debate about whether the tractor would actually last 5 years. The controller insists that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors actually do give 5 years of service. The service manager then states that some last for as long as 8 years.

Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractor’s life on the NPV. Use a 40% marginal federal-plus-state tax rate, a zero salvage value, and a 8% WACC. Assuming each of the indicated lives has the same probability of occurring (probability = 1/3), what is the tractor’s expected NPV? (Hint: Use the 5-year straight-line depreciation for all analyses and ignore the MACRS half-year convention for this problem.)

Round your answers to two decimal places. Do not round intermediate calculations.

a.Tractor’s NPV if actual life is 5 years.

$

b.Tractor’s NPV if actual life is 4 years.

$

c.Tractor’s NPV if actual life is 8 years.

$

d.Tractor’s expected NPV.

$

Please show your work step by step USING A CALCULATOR.

Problem 13-7

Real options

Nevada Enterprises is considering buying a vacant lot that sells for $1.9 million. If the property is purchased, the company’s plan is to spend another $7 million today (t = 0) to build a hotel on the property. The cash flows from the hotel will depend critically on whether the state imposes a tourism tax in this year’s legislative session. If the tax is imposed, the hotel is expected to produce cash inflows of $600,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce cash inflows of $1,800,000 at the end of each of the next 15 years. The project has a 11% WACC. Assume at the outset that the company does not have the option to delay the project.

e. Finally, assume that there is no option to abandon or delay the project, but that the company has an option to purchase an adjacent property in 1 year at a price of $1.5 million (outflow at t = 1). If the tourism tax is imposed, the net present value of developing this property (as of t = 1) will be only $300,000 (so it doesn’t make sense to purchase the property for $1.5 million). However, if the tax is not imposed, the expected net present value of the future opportunities from developing the property will be $4 million (as of t = 1). Thus, under this scenario it makes sense to purchase the property for $1.5 million (at t = 1). Assume that these cash flows are discounted at 11%, and the probability that the tax will be imposed is still 50%.

What is the most the company would pay today (t = 0) for the $1.5 million purchase option (at t = 1) for the adjacent property? Round your answer to two decimal places.