Quiz 2: Corporate Finance - Spring 1998
Please answer all questions. This is an open-book, open-notes exam. You have 30 minutes.
Readers Digest has asked you to analyze an investment proposal that it has received. This proposal relates to Readers Digest producing a CD-ROM version that will contain the text of all of the articles published in the magazine since its inception. You have also been given the following information from the proposal:
- The firm has already completed market testing that suggests that there is a market for this product. This market testing cost $ 5 million, which will be capitalized and depreciated straight line over 4 years.
- Readers Digest will have to invest $ 25 million in new computers, CD-ROM drives and other equipment. This equipment will have a life of 4 years, at the end of which period it is estimated to have a value of $ 5 million.
- During the 4-year period, the equipment will be depreciated straight line down to its salvage value of $ 5 million.
- It is anticipated that 300,000 CD-ROMs will be sold each year for the next 4 years, at a price of $ 50 per CD-ROM. The cost of producing and packaging each CD is $ 10.
- There will be 10 full time employees and the payroll (and other associated costs) for these employees is expected to be $ 2 million a year, for the next 4 years.
- The firm will have to maintain an inventory of 10% of revenues. This investment will have to be made at the beginning of the year, and can be entirely salvaged at the end of the four years.
- The total annual advertising budget for Readers Digest, which is currently $ 25 million, is expected to increase to $ 27.5 million as a consequence of this new product. The firm is planning to allocate 5% of this total expense to this project each year for the next 4 years.
- The firm has a tax rate of 40%.
- Readers Digest has no debt and a beta of 0.80. The average unlevered beta of firms that produce educational and informational CD-ROMs is 1.20. The treasury bond rate is 6%.
a. Estimate the annual after-tax operating income from taking this project. (You need to do this only for the first year, since none of the items are expected to change over time)
b. Estimate the return on capital on this project.( Note that since the depreciation method is straight line, you can just take the average of the initial investment and the salvage value to compute average book value)
c. Estimate the incremental after-tax cashflow on this project. (Again, you need to do this only for the first year)
d. Estimate the net present value of this project.